The coronavirus outbreak has begun spreading to different parts of the world and is beginning to affect financial markets. The outbreak is likely to lead to a negative demand and supply shock which carries with it a number of consequences. There will be a temporary pullback in demand due to decreased economic activity and increased anxiety and caution among consumers and corporations. This can be somewhat offset by loosening financial conditions. Also, it's likely that this demand will be made up at a later date.
But, there is also a supply shock due to the shutdown of large parts of the Chinese economy that will have delayed effects on supply chains which may affect the availability of products and lead to shortages and higher prices. Currently, policies like shutting down travel and commercial activity are solutions that would exacerbate demand and supply shocks. However, they may be necessary if the situation gets worse.
Already, financial markets are beginning to price in this possibility. So far, the S&P 500 (NYSE: SPY) has declined 12.5% from its all-time high set on February 19, just over a week ago. From early October to late February, the S&P 500 gained 20% in a steady ascent. About 2/3 of this advance has been wiped out in six sessions.
On a longer timeframe, the stock market remains in an uptrend, and it looks like it could be testing its breakout at the end of last year to new highs. While the effects of the coronavirus are significant enough to lead to a stock market correction, they are exacerbating the bullish trend in bonds.
Money is pouring into the bond market, leading long-term yields to hit record lows. The 30-year Treasury is yielding 1.79%; the 10-year is yielding 1.30%; the 2-year is at 1.11%; the 3-month bill is yielding 1.45%. These figures indicate that the bond market is anticipating Fed easing, there is wariness about future growth and inflation prospects, and the curve is inverted and/or flat with the tight spread between Treasuries of all durations.
In response, Federal Reserve futures are indicating an 85% chance of the Fed cutting rates at or prior to the March meeting and then a 50% chance of the Fed cutting three more times by the end of the year. Such aggressive Fed action would cushion the blow from any sell-off, and if the coronavirus situation improves, it could lead to massive gains on the upside.