Last month on a Sunday action taken by six central banks will be looked back on as one of the biggest multifaceted and coordinated monetary policy interventions in history. We should always and will always remember that weekend.
Its immediate aim was to avoid what was feared to be a messy market opening because of the flood of negative coronavirus news during that weekend. The risk is that the firing of so many bazookas at this particular stage ends up in my opinion not just being premature for economic well-being but also for maintaining lasting financial stability. And, perhaps, for safeguarding and ensuring the future effectiveness of modern central banking.
The Federal Reserve’s efforts will dominate the headlines given its status as the world’s most powerful central bank. In a “whatever it takes” policy approach (once invented by ECB president Draghi on the Greesubprimek crisis), the Fed slashed interest rates to near zero, announced a 700 billion US-Dollar asset purchase programme (quantitative easing) and, through coordination with the five other central banks, an enhancement of dollar-swap lines.
The need for such a huge central bank intervention relates to fear that further downward pressures on asset prices when the markets opened last month would not only fuel unsetting volatility but also create market malfunction, which could cause a negative spillover from the financial sector into the broader economy. It comes on the heels of what I believe is the critical mass reached over that weekend in the sudden-stop dynamics that have been gradually paralyzing the global economy. More European countries closed their borders, additional businesses and schools were shut down, travel bans were expanded, and some advanced and developing countries effectively imposed countrywide shutdowns.
To work in sustainably stabilizing markets, this Fed intervention in my opinion needs to overcome five concerns, which is please understand far from automatic:
First, while helping balance-sheets and facilitating favorable mortgage refinancing, such measures will have no effect in restoring economic activity for the time being. Simply put, neither a lower cost loan nor cash in pocket from lower mortgage payments will encourage people to travel and re-engage in economic interactions.
Second, the liquidity injection will help high-quality bonds and perhaps even enhance banks’ willingness to extend credit to minimize the risk of corporate liquidity problems becoming solvency ones. But the effect on other segments of finance, including corporate bonds, is a lot less direct at this stage.
Third, with the reduction to near zero interest rates, the Fed has essentially exhausted the interest-rate mechanism at a time of more limited policy effectiveness because of strained policy transmission mechanism – or what is likely to be called the risk of a premature firing of a big bazooka. The notion of going negative on rates is undermined by growing evidence from Europe about the risk of counterproductive economic and financial outcomes, as well as concerns about the viability of the money market sector, especially after the shock of a fund breaking the buck in September 2008.
Fourth, all this complicates the important market challenge the Fed faces of attracting sufficient deep-pocketed buyers back into the stock market. The more such buyers hesitate to engage, the greater the risk that the huge Fed intervention (including the 2 trillion aid proposed by Trump and to be approved by congress) is simply treated as potentially providing a bigger door for trapped longs and other distressed sellers to exit. Should this materialize, markets in my opinion will trade down ahead of such anticipated selling.
Fifth, to avoid yet another Fed communication mishap, the policy intervention needs to be packaged in a manner that reassures markets that this is part of the path to normality. While I hope I am wrong, I worry that the first three press statements posted last month do not fulfil this condition yet.
The Fed, having initially contributed inadvertently to the multi-year decoupling of elevated asset prices from more sluggish fundamentals, has just gone “all in” in an attempt not just to pre-empt market malfunction but also preserve its credibility standing, and, perhaps, political autonomy.
It’s a by no question mommental policy bet that I hope works, but I worry that, at least for now, it does not appear to have comforting overwhelming odds of success.
So question remains, where is the real problem? How could a possible solution to the current financial crisis look like?
In my opinion the coronavirus threatens to set off financial contagion in a world economy with very different vulnerabilities than on the eve of the global financial crisis, 12 years ago. And I have written and spoken about it many times before. In key ways the world is now as or more deeply in debt as it was when the last big crisis hit. But the largest and most risky pools of debt have shifted from households and banks in the United States, which were restrained by regulators after the last financial crisis, to corporations all over the world.
As businesses deal with the prospect of a sudden stop on their cash flows, the most exposed are a relatively new generation of companies that already struggle to pay their loans. This class includes the “zombies” – companies that earn too little even to make interest payments on their debt, and survive only by issuing new debt.
The dystopian reality of deserted airports, empty trains and thinly occupied restaurants (if open) is already badly hurting economic activity. The longer the pandemic lasts, the greater the risk that the sharp down turn morphs into a financial crisis with zombie companies starting a chain of defaults just like mortgages did in 2008.
Let’s take a look at the history. Over the last century, recessions have almost always been started by a sustained period of higher interest rates. Never a virus: The damage such contagions inflicted on the world economy typically lasted no more than three months. Now this once-in-a-century pandemic is hitting a world economy saddled with record levels of debt.
Central banks around the world are waking up to the prospect that the cash crunch can beget a financial crisis, as in 2008. That’s the real reason in my opinion why the Federal Reserve took aggressive easing measures last month that were straight out of the 2008 crisis playbook. While it is unclear whether the actions of the Fed will be enough to prevent the markets from panicking further – which I personally doubt-, its work asking:
Why does the financial system feed so vulnerable again?
Around 1980, the world’s debts started rising fast as interest rates began falling and financial deregulation made it easier to lend. Debt tripled to historic peak of more than three times the size of the global economy on the eve of the 2008 crisis. (just imagine that to a corporation which has three times its debts to its turnover on average). Debt fell that year, but record low interest rates soon fueled a new run on borrowing.
The easy money policies pursued by the Federal Reserve, and matched by central banks around the world, were designed to keep economics growing and to stimulate recovery from the crisis. Instead, much of that money went into the financial economy, including stocks, bonds and cheap credit to unprofitable companies.
As the economic expansion continued, year after year, lenders grew increasingly lax, extending cheap loans to companies with questionable finances. Today the global debt burden is again at an all-time high and the coronavirus will cost additional trillions of US-Dollars which governments and central banks will throw in to stabilize the economy and financial markets.
The level of debt in America’s corporate sector amounts to 75% of the country’s gross domestic product, breaking the previous record set in 2008.
Among large American companies, debt burdens are precariously high in the auto, hospitality and transportation sectors – industries taking a direct hit from the coronavirus.
Hidden within the 16 trillion US-Dollar corporate debt market are many potential troublemakers, including the zombies. They are the natural spawn of a long period of record low interest rates, which has sent investors on a restless hunt for debt products that offer higher reward, with higher risk. Zombies now account for 16% of all the publicly traded companies in the United States, and more than 10% in Europe, according to the Bank for International Settlements, the bank for central banks. A look at the data reveals that zombies are especially prevalent in commodity industries like mining coal and oil, which may spell upheavals to come for the shale oil industry, now a critical driver of the American economy.
But zombies are in my opinion not the only potential source of trouble. To avoid regulations imposed on public companies since 2008, many have gone private in deals that typically saddle the company with huge debts (leveraged buy-outs). The average American company owned by a private equity firm has debts equal to six times its annual earnings, a level twice what ratings agencies consider “junk”.
Signs of debt stress are now multiplying in industries impacted by the coronavirus, including transportation and leisure, auto and, perhaps worst of all, oil. Slammed on one side by fear that the coronavirus will collapse demand, and on the other by fears of supply glut, oil prices have fallen to below 30 US-Dollar a barrel and can in my opinion even go below 20 US-Dollar a barrel – far too low for many oil companies to meet their debt and interest payments.
Though investors always demand higher returns to by bonds issued by financially shaky companies, the premium they demand on US junk debt has nearly doubled since mid – February. By last month the premium they demand on the junk debt of oil companies was nearing level seen in a recession.
Though the world has yet to see a virus-induced recession, this is now a rare pandemic. The direct effect on economic activity will be magnified not only by its impact on balky debtors, but also by the impact of failing companies on the bloated financial markets. It is in my opinion most probably will end up in a “blood-bath”.
When markets fall, millions of investors feel less wealthy and cut back on spending. The economy slows. The bigger markets get, relative to the economy, the larger this negative “wealth effect”. And thanks again to seemingly endless promises of easy money, markets have never been bigger. Since 1980 the global financial markets – mainly stocks and bonds – have quadrupled to four times the size of the global economy, above the previous record highs set in 2008.
On Wall Street, bulls still hold out hope that the worst can pass quickly and point to the encouraging developments in China. The first cases were reported there on December 31st, and the rate of growth in new cases peaked on February 13th, just seven weeks later. After early losses, China stock market bounced back and the economy seemed to do the same. But the latest data, released last month on retail sales and fixed investment, suggest the Chinese economy is set to contract this quarter.
While China is no longer center stage, as the virus spreads worldwide there are renewed fears that the crisis could circle back to its shores by hurting demand for exports. And it more and more looks like that this fear become reality with the current development of the virus. Over the last decade China’s corporate debt swelled fourfold to over 20 trillion US-Dollar – the biggest binge in the world. The International Monetary Fund estimates that one-tenth of this debt is in zombie firms, which rely on government – directed lending to stay alive.
In other parts of the world, including the United States, calls are growing for policymakers to offer similar state support to the fragile corporate sector. No matter what the policy makers do, the outcome – as sad as it is – is now up to the coronavirus, and how soon its spread starts to slow.
The longer the coronavirus continues to spread at its current pace, the more likely it is that zombies begin to die, further depressing the market – and increasing the risk of wider financial contagion.
One thing is for sure. The coronavirus is a very different event than the financial crisis 12 years ago. It is a large shook to demand and incomes, and the process is moving much more quickly. We also must recognize that what the Fed and other central banks can do is limited. Short – it’s not looking good at all!