The monetary and fiscal policy response to the epidemic globally has been unusually quick and effective. In two weeks, core response elements relating to economic and financial challenges have been put in place to prevent the health crisis from morphing into a broader crisis. Effective health policy and innovation will be needed, however, before our working lives, economies and markets can normalize.
Governments have been caught flatfooted and are scrambling to deploy strategies and assets to combat the virus. Time will bring more technology, data, testing, therapies, best practices and ultimately a vaccine to this battle. We will face the Fall outbreak in the Northern hemisphere from an entirely different and more prepared starting point. Jeff Elliott on our team is monitoring the virus progression, helping us assess the duration of the distancing interventions and gauging the prospects for therapeutic responses.
The lockdown and travel bans have produced a sudden stop to real economic activity. This has triggered extreme volatility in asset prices as markets have had to reassess growth expectations and introduce default probabilities in their credit risk measures. Whether in lodging, aerospace, retail or energy; investors have extensive exposures to impacted businesses; in many cases these are held through securitized instruments which provide no way to hedge other than by liquidating the full block of exposures. Credit ETFs epitomize this phenomenon and have introduced an additional dimension of contagion as we saw in the Fall of 2015, as investors exited high-yield ETFs in droves to rid themselves of the embedded energy risk.
If credit markets break down and companies can’t refinance their short-term debt maturities, it can trigger a liquidity crisis – which can quickly lead to a solvency crisis. This crisis has spilled into credit, and there have been some hard-wired responses to that.
Liquidity risk plagues shadow banking system
Consider the lessons that treasurers and chief financial officers learned during the 2008 Great Financial Crisis and the euro crisis. If they anticipate 6-18 months of highly uncertain cashflows, they immediately draw down their credit facilities and sell money market funds to hoard U.S.-dollar liquidity. This was the reaction the world over and in the process drove up the U.S. dollar. Banks themselves sought to ration capital to brace for defaults and the possible loss of their own funding bases. The loss of liquidity in fixed-income markets emerged in short-term instruments first – explained by the roughly US$150 billion being withdrawn from U.S. prime money market funds. Money managers looking to liquidate this high-quality paper found no buyers as their peers also sought to preserve liquidity. Banks were unwilling to absorb it. Another entity was needed to do that…to prevent a system freeze up.
The system lender of last resort, the U.S. Federal Reserve (the Fed), promptly launched a facility to purchase commercial paper. Similar programs for high-grade corporate bonds, mortgages, municipal bonds, brokerages, small business loans and government bonds were launched thereafter. Strategies devised by Tim Geithner at the U.S. Treasury and Ben Bernanke at the Fed in 2008 have been reactivated in the past two weeks to address bottlenecks in the financial plumbing and to prevent the valves from blowing.
In recent years, there has been a proliferation of quantitative investment strategies that target a specified level of volatility (which some investors directly equate to risk). The strategies are meant to liquidate risk when volatility rises above target. When volatility spiked from 9 to 85 de-leveraging took hold, especially because these strategies were fully engaged in risk in January. Hedge funds undertook a similar deleveraging as volatility spiked. As in credit markets, the deleveraging in equities was met with no natural counterpart to absorb the risk assets being sold. In the midst of the deleveraging, the price declines for stocks and bonds comprised of this liquidity discount over and above the growth/credit risk discounts. On account of this widespread market failure and ultimate call on government backstops for liquidity, I have dubbed the episode a mega flash crash and the peak of the shadow banking era.
The Dodd-Frank and Volker rules of 2010 destroyed the market-making function that the banking system once provided. Prudent post-crisis bank reforms limited the growth of bank balance sheets over the past decade. These restrictions on incumbents opened the door for less regulated so-called shadow banks to grow –electronic brokers, ETFs, asset managers, pensions and hedge funds. Collectively, they are the agents of market finance as opposed to bank finance. The size of the corporate bond market has ballooned since 2008, and yet the capacity to transfer that risk across the system has shrunk. In response to a large shock, a liquidity accident was probable. Former Head of the G20 Financial Stability Board and Bank of England Governor Mark Carney postulated years back that in such a circumstance central banks would be called upon to absorb risk and prevent fire sales from taking hold. In response to this market failure having happened, expect regulators to turn their eyes toward shadow bank liquidity issues.
On the fiscal side, this isn’t a conventional, slow-moving recession but rather a sudden stop that requires a bridging of household and small business cash flows. Be it tax relief and deferrals, direct cash payments, interest or rent holidays – numerous bridging strategies will be invoked by governments globally.
The combination of these efforts has sharply reduced the risk of a domino effect. Economic and financial stresses could persist, and rating downgrades will accelerate, but an initial bridge over the health crisis has been constructed. Markets have responded to the policy led reduction in liquidity risk by stabilizing values in fixed income and equities. Looking ahead we face a massive government borrowing spree funded by in large part by central banks. How central banks engineer the low interest rates required for this borrowing to be sustainable will shape the next decade of investing.
Sources: Bloomberg L.P. and Signature Global Asset Management, March 27, 2020.
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Published April 1, 2020