Three concerns demanding market attention over the past week

Policymaker responses to the coronavirus pandemic throw up new questions and concerns about the consequences for economies and markets every week. The last week has been no exception, with three prominent issues at the forefront of market attention.

The first was an intensification of fears about renewed US-China trade and financial market tensions. Two weeks ago, President Donald Trump called Covid-19 an attack on the US similar to Pearl Harbour or 9/11, blamed China and threatened retaliation.

Steps were taken last week to punish China. Mr Trump directed a US pension fund managing the pensions of millions of federal employees not to invest in Chinese companies and said the US could “cut off the whole relationship with China”. The US also tightened restrictions on Huawei.

Before this crisis, markets hoped that US-China trade relations were on the mend. Now, they not only appear to have worsened, but are also straying into the realm of financial markets and trade.

With China the second-biggest foreign holder of US Treasuries, this carries enormous risks if it were to respond.

It appears markets will have to endure many more months of heightened threats, counter threats, sanctions and retaliation, which will probably keep risk aversion elevated, especially in a US election year.

The second issue this week revolves around speculation that the monetary and fiscal policy consequences of the crisis are moving more fully to centre-stage. On the monetary policy side, there has been mounting speculation about the prospect of negative rates in America. US Federal Reserve chairman Jerome Powell, however, emphasised his opposition to negative rates during the week, with other Fed officials also dismissing the strategy as inappropriate for the US at this juncture.

Mr Powell confirmed that “the committee’s view on negative rates really has not changed. This is not something that we are looking at”. To some extent the markets’ moves are understandable, as the possibility of deflation is being confronted for the first time since the global financial crisis, with growth contracting in the first quarter – and set to deteriorate in the second quarter – and inflation turning negative.

In such circumstances it is natural for some banks to hedge against the possibility of deflation, just as it will also be natural for others to buy inflation hedges if they are fearful of unlimited quantitative easing spilling over into resurgent price pressures down the road.

At the moment, the deflation threat clearly has the upper hand, but this trend could quickly reverse once the pandemic begins to retreat.

Finally, fiscal policy responses to the crisis also received attention, with Saudi Arabia announcing a trebling of VAT along with some other measures to contain the budget deficit in response to the sharp decline in oil prices this year.

The UK Treasury also produced a paper on the steps that may need to be taken to repair a £300 billion (Dh1.33 trillion) hole in the UK government’s finances in the aftermath of the crisis, including tax rises and spending cuts. The policy paper drew sharp criticism, however, with suggestions it would be “economic suicide” to raise taxes to slash the deficit.

The government was urged to ignore the debt for now and promote growth. By doing that, the budget deficit would take care of itself as the economy expands, being paid off very slowly over many years, rather than with sudden tax hikes.

This may also have relevance for Saudi Arabia, which might benefit from more pro-growth, countercyclical policies, even as oil prices remain weak.

The deflation threat has the upper hand, but this could quickly reverse once the pandemic begins to retreat