20 March 2020
Market in turmoil
The Fed has cut rates nearly to zero, launched a $700 billion bond buying programme and co-ordinated with other major central banks on US dollar swap lines. It has resurrected financial crisis era programmes such as commercial paper purchases and money market fund support. But all these measures have failed to calm markets amid fears of a global recession.
Volatile conditions have pushed up bid-offer spreads triggering industry outflows. This is an unprecedented economy-wide liquidity shock, crowning cash as king even at negative rates. Now more than ever, we need an imaginative debate about policy tools that would show willingness by the Fed to adapt more quickly in these extraordinary times.
Bringing back TALF and TARP to help affected sectors
While easing short-term funding pressures and supporting the flow of credit to households and businesses are welcome steps, markets also need to hear that the Fed is actively considering additional measures to help solvent companies and sectors bridge their short-term cash flow issues.
Revitalising old programmes such as the Term Asset-Backed Securities Loan Facility (TALF) and the Troubled Asset Relief Program (TARP) will require legislative assistance but the structure exists to apply these facilities to affected economic sectors.
One of the key areas of discussion among market participants currently is the idea that some branch of the government needs to absorb the “first loss piece” of any such programmes to promote confidence. Specifically, the Fed and other agencies may need to provide guarantees or backstops to unlock access to liquidity, particularly for smaller businesses. I believe that policy makers will consider such suggestions, but the private sector will also need to participate to ensure a reasonably quick rebound in economic activity once the public health crisis passes.
Additionally, support for small businesses may slip through the cracks of the larger banks’ lending policies so effective programmes will be needed for the regional and community banking sector in conjunction with agencies such as the Small Business Administration. This will be crucial to keeping people in their jobs.
Using the discount window
As well as improving credit lines, removing the stigma of using the ‘discount window’ and providing the banking system with a degree of regulatory capital forbearance will also ease liquidity. The window is meant to provide emergency liquidity to banks facing a credit squeeze, but banks have been reluctant to use this facility because of the reaction it can provoke from investors, who may worry that it reveals more serious problems. Expanding the range of eligible collateral that banks can post in return for liquid assets can also help short- circuit the disorderly rise in market liquidity premia.
We also know the banking system has ample capacity to lend given that loan-to-deposit ratios are at generational lows (chart 2). Key banking executives have expressed their willingness to assist, which is no surprise given that the sector tends to enhance profitability when lending into a recession.
Focus on liquidity as dispersion rises
As the pandemic continues to hurt economic activity, spread dispersion is likely to keep rising. When recessions occur and affect credit quality, defaults get factored into spreads well before losses are crystallised. In the last two US recessions, high yield spreads have pushed out towards 1000 basis points. For investors with an intermediate term horizon, spreads approaching those levels are typically an excellent time to add exposure, but the ride will be turbulent for some time before the tailwinds develop.
Normally, we welcome some increase in dispersion in credit markets as an opportunity to add risk, but our immediate focus is portfolio liquidity and credit exposure stress test analysis in order to preserve value and ensure we are invested in those companies most likely to survive this crisis.
Winners and losers
The recent oil price shock has also created winners and losers, with the future viability of many issuers in public capital markets under threat. This includes not only smaller shale producers but also the oilfield services sector. Energy’s weight in the US HY indices has already plummeted from more than 12 per cent down to 9 per cent over the last few weeks. In the short run, energy will remain under pressure but perversely may return to growth in terms of index share when investment grade borrowers see their credit ratings downgraded to high yield.
In due course, the oil market will rebalance and the virus will run its course and be met with research-based responses. In line with previous historical episodes, the extreme spike in volatility will abate. Until then, markets will pressure governments to spend money and central banks to unveil innovative policy measures - such as extending QE programmes to a wider range of assets. The sooner and more boldly these are introduced, the sooner calm can be restored.
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