A trader reacts to the steep losses posted on the New York Stock Exchange on Monday, March 16, 2020. Photo: Johannes Eisele / AFP

US President Donald Trump’s late-afternoon warning that the health crisis could last until July or August and that the US economy could suffer a recession provoked a late wave of selling that took the S&P 500 down 12%, the worst trading day since October 1987. The US small-capitalization stock index, the Russell 2000, lost 14%, its worst day in history.

Extreme measures to support the US economy now are being mooted, including unlimited purchases of municipal bonds by the Federal Reserve, that is, printing money to support local governments – something the US central bank never has done. The dollar price of State of Illinois bonds due in 2027 has fallen from about $124 on March 1 to $106 on March 16, and many state and city officials fear that the collapse of sales taxes and other revenue sources will push them into financial distress within a couple of months.

Proposals are circulating in Congress to raise unemployment insurance to 75% of previous salary, from the present level of about 45%. Senior staff on Capitol Hill describe the political situation around such proposals as fluid. The additional unemployment insurance payments would have to be supported by federal subsidies to states.

Never have investors had to digest uncertainty on this scale. With large parts of the US economy shutting down, a protracted health emergency lasting into late summer could provoke a sharp economic downturn, with devastating consequences for large sections of the economy and financial system. The worst performer on the S&P 500 was the top retail Real Estate Investment Trust, Simon Property, down 27% on the day, and down by nearly two-thirds over the past year. It was followed closely by Lowe’s Companies with a 25% fall. On the S&P 500, last place was occupied by MGM Resorts.

The US has $15.8 trillion of outstanding mortgage debt, of which $11 trillion is residential and $3 trillion is commercial. Retail and hotel debt is the most exposed in the present crisis, and a high default rate would have severe consequences for the banking  system.

The best performer on the S&P 500 was Walgreens. Investors figure that people still will need pharmacies.

The potential scale of economic contraction is daunting. China overnight released data showing a 20.5% decline in retail sales, a 16.3% decline in property investment and a 13.5% fall in industrial production. China’s economy is coming back online, while most of Europe is gradually grinding to a halt. The United States has no way of gauging where it stands. Most investors assumed that the health crisis might last a couple of months. Trump’s warning that it might stretch out for another five months was a thunderbolt out of a blue sky. It is not clear how that estimate was determined.

Governments are fighting fires in several directions. A run for cash last week provoked an extreme liquidity crisis in the banking system, as US bank customers suddenly drew down their credit lines from commercial banks, and commercial banks rationed credit around the world. European and Japanese banks suddenly found themselves unable to renew short-term credit lines with US banks, resulting in extreme swings in interbank loan pricing. Foreign banks and institutions liquidated what dollar assets they could, including US Treasuries and government-issued mortgage-backed securities.

On Sunday, the US Federal Reserve and the Bank of Japan took emergency measures to provide liquidity to a market seized by balance-sheet shrinkage. The Fed cut its overnight lending rate to near zero, scheduled $500 billion of permanent securities purchases, and opened US dollar swap lines to foreign central banks to provide liquidity, with limited effect.

The Fed’s action took the edge off – but did not reverse – the liquidity crisis in the banking system. The most sensitive gauge of funding pressures for Japanese banks, the cross-currency basis swap, closed Monday at its lowest level in history, indicating that forced sales of US securities by foreign investors will continue.

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