Apr 13, 2020
• Fed comes back to the market with a further wave of unprecedented support
• A further $2.3 trillion and they may still not yet be done
• The purchase of junk bonds comes with huge moral hazard
• The Fed’s emergency’ action now spans over a decade
• We suspect that the Fed has just accelerated the dollar’s demise as the pre-eminent fiat currency
• 50% of Japan reverts to lock-down – Japanese government comes with modest response
• Data from China is likely to show solid recovery in activity
The Federal Reserve’s move to prop up even the junk bond market is further evidence that truly free capital markets are a thing of the past. It is clear that for the Fed, moral hazard is no longer a cause for concern if ever it was through the past decade. Emergency policies have become the norm as the US establishment continues to feed a mistaken belief that equity markets must rise forever and that economic cycles should not exist. Investors may continue to make hay buying risk assets again. At the same time, the inevitable day of reckoning for the US economic system will have to wait but may come sooner rather than later.
I don’t know how many kitchen sinks the Federal Reserve has, but they have thrown yet another at the US economic problems in the past week. The Fed keeps characterising the situation as an emergency of some kind, but unfortunately, we have been having seeming crises ever since 2007, and they are not abating.
Remember that the Fed characterised QE1, 2 and 3 as emergency support for the US financial system and economy. However, the Fed has since institutionalised ’emergency’ support as an ongoing support of a broken economic system.
The issues of the moral hazard of the Fed’s actions have been pushed to the background. COVID-19 may be an exceptional event. However, the US corporate sector was not in any fit state to fight any particular crisis. Hence the need for the Fed to step in and save the day. US corporate debt to GDP has risen by nearly $4 trillion since 2009 to $10 trillion, equivalent to 46% of GDP in 2019. Add in the debt of small and medium-sized enterprises and the aggregate corporate debt rises to 74% of GDP.
In the middle of last year, Fitch the rating agency was warning about the leveraged loan and below investment grade bond markets. In June 2019 Fitch increased by 35% in one month alone its list of Top Loans of Concern List. The corporate sector didn’t use the opportunity of one of the longest economic expansions on record to save funds in reserve for difficult times. Instead, they went on a borrowing binge. No CEO to our knowledge is being called to task for abject corporate management.
The Fed is now reaping what it has sown. For years they have run an inappropriately loose monetary policy that only encouraged imprudent behaviours among corporates and investors. Companies are in trouble under the burden of the debt that they have taken on in recent years. And remember these companies are in trouble even with near-zero interest rates.
In a further effort to underpin the corporate sector, the Fed extended a further $2 trillion of liquidity. In detail, the Fed will purchase up to $600 billion of qualifying loans from the Main Street programmes. In essence, it is supporting small and medium-sized enterprises. The Fed has also expanded its primary and secondary market corporate credit facility by broadening the range of assets that are eligible for purchase. The Fed is committed to buying junk bonds, but only on the premise that the debts were downgraded to junk due to the effects of the virus.
Initially, the Fed had limited its activity to mending the broken plumbing in the (usually) liquid parts of the bond and money markets. After some initial wobbles in the mortgage-backed market (and perhaps this one is not entirely out of the woods yet) things started to move in the right direction. Liquidity came back, and volatility began to ease. However, severe strain remained in the credit market. It had gotten to the point that the simple function of price discovery was impaired, especially in the weaker parts of the credit spectrum.
Last Thursday’s announcement changed the picture.
Among the various actions taken by the Fed was its decision to begin buying exchange-traded funds (ETF’s) that hold corporate debt. Not only will they purchase investment-grade ETFs and bonds, but also high-yield ETFs and some fallen angel bonds. Unprecedented indeed. These interventions need some explanation.
First, the Fed’s purchase of investment-grade bonds does not extend to bank bonds. Presumably, it is to avoid the potential conflict of interest in holding the debt of the very industry it is supposed to be overseeing.
This time, in a reversal from 2008, everybody except the bankers is in line for bailout money. There is the additional point that the bigger banks globally, and in the US banks, in particular, are going into this recession with what looks like sufficient balance headroom to come out in good shape. They are more likely to be part of the solution (getting funding to where it is most needed) than the problem, which is the apparent effect on industries across aboard of a sudden stop in economic activity. So much for prudent balance sheet management by the banks. It has reserved a spot at the back of the bailout queue.
Second, not every high-yield bond is eligible, even if high-yield ETFs can be purchased. In direct bond purchases, there is a limit extended to fallen angels – bonds that have been downgraded from investment grade to no lower than BB-/Ba3 since the 20th of March.
Make no mistake about it; we have just witnessed a full-scale bailout of large swathes of the ETF market. When the history of this crisis is written, there will be serious questions over the role of fixed income ETFs: municipal bonds, high-grade credit, and high-yield credit. Some of what transpired may never become public, but it is clear for all to see that the pre-crisis promise of deep liquidity in ETFs was a false one. When confidence in the underlying asset became an issue, the ETFs buckled under the strain. What appears to have happened, as evidenced by the yawning discounts to fund NAVs that opened up, the ETFs were not providing liquidity (as often claimed pre-meltdown). Instead, they were fuelling the rush for the exit as retail and institutional investors alike found pricing to be even more disadvantageous in the ETFs than in the actual market.
Longer-term we suspect that the Fed has just accelerated the dollar’s demise as the pre-eminent fiat currency. If the Fed couldn’t extract itself from the support it gave the US economy in 2009, how will it find an exit path from here? The policymakers have tried to cancel the economic and market cycle for fear people may actually lose money. Any sign of inflation in the future could bring a precipitous collapse in the dollar. The market will take the view that there is no way that the Fed could raise rates with such a heavily indebted country. A dollar without defences will at the mercy of the markets…. It won’t be pretty.
However, even with the support of the bailout, some analysts in the market believe the Fed will not be done with its actions until they are forgiving debts and buying the equity market. “Free money is what the economy needs now, not a helping-hand loan that needs to be paid back,” said Chris Rupkey, chief financial economist at MUFG Union Bank. Quite frankly we wouldn’t rule out such actions. The Fed has well and truly ripped up the rule book.
The US was not alone in cranking up the policy response last week. Japan announced a package of measures that amount to a fiscal boost of just 3.0% of GDP as they declared a month-long state of emergency in seven prefectures covering half of the country. Economists are expecting Japanese 2020 GDP growth of -4.5%. The virus and subsequent lockdown have particularly hurt the consumer sector already hit by the imposition of additional sales taxes. Consumer confidence has fallen to levels last seen in 2009, while small company confidence has fallen to an all-time low.
The markets will be looking to Chinese economic data next week for clues as to how the rest of the world might eventually emerge from the crisis. Industrial production and retails sales growth should be up 35% and 60% month-on-month respectively. The level of retail sales will even after such a recovery be 30% below the December 2019 base.