Now We are Getting Serious

There is folklore among many investors that is preventing an understanding of what is happening. The fiction is that the Fed has killed the last three expansions by pursuing too tight of monetary policy. In fact, the previous three downturns were caused by financial crises (the S&L Crisis, the Tech Bubble, and the Great Financial Crisis) that spilled over and hit the real economy. If anything, policy was too accommodative for too long, and regulatory authority was too lax. This time it is a shock to the real economy that is threatening a financial crisis. The volatility has exploded and forcing margin calls, distressed liquidation, illiquid conditions in the biggest and deepest markets, like US Treasuries. Corporations are drawing down credit lines, which impacts banks’ liquidity.

The Fed has already taken several steps to help minimize the systemic financial risks stemming from the real and anticipated economic shock. It delivered a 50 bp emergency rate cut, boosted the size of its repo operations, and introduced a new one-month term repo.  As stocks were cratering on March 12, the Fed announced a $500 bln three-month repo operation (and more to come). It also signaled a resumption of QE by announcing it would buy government bonds across the curve matching the maturity profile of the outstanding marketable Treasury securities.

Ahead of the weekend, it conducted another $500 bln three-month operation and a $500 bln one-month repo. Similar operations are planned for the week ahead as well. However, the challenge with this approach is that it still requires the banks to participate and then to re-lend. Consider that beginning with the unexpected $500 bln three-month repo operation on March 12 and the same on another one on March 13 alongside a $500 bln made available in one-month repo operation, the banks drew less than 10% of the funding made available.

The Fed’s work is not done. The playbook, as it were, says then when close to the zero-bound, it is essential to act swiftly and deliberately to be effective. The current fed funds target is 1.00%-1.25%. The market is pricing in a 100 bp cut by the FOMC next week that will bring the target range to the low of Great Financial crisis of 0.0-0.25%. Fed officials have debated the risks and rewards of negative interest rates, and they seem determined to respect the zero-bound.

It does, though, raise the issue of what it will pay on reserves. Although many, including some Fed officials, talk about interest on excess reserves (IOER), the Fed pays interest on required reserves as well.  Paying interest on reserves was an authority granted to the central bank during the GFC.  It is not clear if authority allows it to  “pay” a negative yield.

There are crisis-era facilities the Fed could resurrect to ensure that the financial system does not breakdown under what could be an economic tsunami. Economists are slashing growth forecasts and now, with suggesting a recession, by which they mean two contracting quarters of GDP, has likely begun. During the Great Financial Crisis, the Federal Reserve helped support commercial paper issuance (Commercial Paper Funding Facility 2008-2010), by essentially creating a backstop funding mechanism. The Fed also helped facilitate consumption (Term Asset-Backed Loan Facility 2009-2010) through purchases of asset-backed securities collateralized by student loans, auto loans, credit cards, and Small Business Administration loans.

Such measures have been criticized in part because they blur the separation of monetary and fiscal policy.  And that is the point: because it is not, in essence, a financial crisis, monetary measures are having a limiting impact on the animal spirits and investor confidence. If the drop equities and yields stalled ahead of the weekend, it was arguably linked to two fiscal developments.

The first was in the US. House Speaker Pelosi initially threatened to vote on a spending bill and delivered a fait accompli to the White House that had not presented a plan besides calling for a payroll savings tax cut. She hinted a deal was close late on March 12. Pelosi also maneuvered so that the Republican-led Senate was forced to postpone next week’s vacation. Late Friday, a deal was struck, and the House approved it. With the President’s support, the Senate will likely pass it on Monday. Trump gradually recognized the severity of the challenge and declared a national state of emergency, which frees up $50 bln in funding and waived interest on all federal student loans.

Instead of selling oil out of the Strategic Petroleum Reserve as this year and next year’s budget agreements require, Trump wants to take advantage of the steep decline to top up the reserves. This could be an indirect way to support US producers.Sounds interesting, even if a distraction from more urgent issues, but there is less than meets the eye. The SPR can hold about 715 mln barrels. It currently has about 635 mln barrels. There is scope to buy around 80 mln barrels or 225k barrels a day for the next year.   

The other fiscal development was in Germany. We had previously noted that Merkel’s tone had changed earlier last week. Still, it was slow to percolate higher until the end of the week when several fiscal measures were announced deferring tax payments (as the US did by executive decision) and a loan commitment via KfW with 550 bln euro (~$610 bln) capacity. Even under the ordoliberalism precepts and its resistance to the calls, especially from debtors, to embrace Keynesian demand management, there is room to respond to emergencies. It does not mean the “black zero” is dead. It means it may not be as masochistic as it is often accused.

The EC is on the verge of formally declaring what it recognized for Italy and relaxed fiscal and state-aid to business rules. The EU’s own investment fund can be scaled up if necessary. It currently guarantees 8 bln euros of loans 100k small and medium-sized businesses. It announced a 37 bln euro “Corona Investment Fund” that would use budget reserves to support companies and health-care systems.

The Bank of Japan meeting concludes the day (March 19) after the FOMC meeting. Although the connection is tangential at best, the fact that the ECB did not cut its rates deeper into negative territory was seen as a hint that the BOJ may not feel obligated to cut rates either. This does not mean that it won’t do anything to complement the two sets of emergency measures that the Abe government has announced.

It could boost its ETF purchase target from the current JPY6 trillion (~$58 bln) a year. It has already bought more than JPY500 bln this month, which just half over. It can scale-up its loan program to support both commercial paper and corporate bonds. It may also extend the maturities of the corporate it purchases and increase the range of bonds it buys to include, for example, local government bonds and government-guaranteed notes. 

Japanese officials get concerned about the yen as below JPY105. However, there is little they could effectively do. The bar to unilateral intervention is high as it would risk the ire of the mercurial American President. Moreover, the valuation is not stretched. According to the OECD’s model of purchasing power parity is slightly under-valued (PPP ~JPY103.35). When thinking through the flows, remember that given the stock of current investment and the wide interest rate differentials, currency hedging can be the critical element to total returns. There has been a real shortage of dollars by yen accounts, as reflecting in the cross-currency basis swaps, which are at two-year extremes, the LIBOR/OIS spread. 

Ahead of the weekend, China announced a cut in required reserves for some commercial lenders to promote lending to small and medium-sized businesses, which frees up about CNY550 bln (~$80 bln) for new lending. On the 20th of each month, China’s Loan Prime Rate is set based on a survey of participating banks. It fell 10 bp in February to 4.05%. The cautious call is for another 10 bp decline. It is more likely to be larger than smaller. Meanwhile, a range of indicators suggests that Chinese factories are re-opening, but the demand shock is beginning to be seen too.

Just as last week was winding down, the Bank of Canada surprised with a 50 bp rate cut, quickly following on the heels of a similar move at the scheduled policy meeting on March 4. The emergency cut was delivered alongside Ottawa’s new efforts to support small and medium-sized businesses by funding the Business Development Bank and Export Development Bank (C$10 bln). After the Fed’s likely rate cut, the 75 bp Bank of Canada bank rate will be the highest in the G7. Given the shocks, another rate cut next month cannot be ruled out. There was not much of a reaction by the Canadian dollar to the surprise rate cut and fiscal announcement, but as the equity market strengthened, the Loonie recovered somewhat. 

While fiscal and monetary efforts are necessary, they may not prove sufficient. The markets are incredible aggregators of information, and until the peak of the pandemic, it is difficult for investors to discount the likely impact. Chancellor Merkel opined that 60%-70% may be vulnerable to infection by the virus. If lower population density, greater numbers that can work from home (~30%), the end of the normal flu season, helps keep the US contagion to an optimistic 40% that is around 130 mln people.

There are other measures officials can take if needed. Italy and Spain introduced one-day bans on short-sales of some sectors ahead of the weekend. A broader and longer ban or more aggressive uptick rules may be considered. Declaring a bank holiday and shutting the markets for a few days may withstand a cost-benefit analysis under certain conditions. The purpose of these measures would give time to investors and businesses to see developments, and it could also help forestall the economic crisis become a financial crisis. There are permanent swap lines between the Federal Reserve and several foreign central banks (ECB, Bank of Canada, Central Bank of Mexico, Bank of England, Swiss National Bank, and the Bank of Japan). The central banks can secure dollars from the US and distribute them via auctions to their member banks.

The G7 will hold a video call on Monday, and there are new hopes of coordination, but it is not clear what can be coordinated at this point. Everyone is moving ahead within their own political and institutional framework. A bank holiday, some limit on short sales, and intervention to counter undesirable levels of volatility in the foreign exchange market would be more effective if coordinated, but these do not appear on Monday’s agenda.   


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