As we sit here in the middle of April, the timing seems right to reflect on this crisis and the different phases along the way. In such a short period of time, the amount of destruction and angst globally has befuddled the best and brightest minds across medicine, government and finance. In reality, and when looking at this objectively, the events leading up to where things are today were missed by many. Yet, at the same time it feels very likely that as the dynamics of the virus perhaps get better from a health perspective, there are still many unknowns moving forward with the dialogue turning quickly toward reopening, economic concern and risk asset valuations. Although risk markets have traded well, the evolution of this crisis will very likely present challenges as the economy deteriorates further and challenges central bank liquidity.
There is no solace in the numbers around coronavirus getting better. Watching the numbers globally each day, although improving, have been a life changing event for so many. Our thoughts and prayers go out to all those that have lost loved ones and the individuals putting their lives on the line each day to save lives and protect our health and safety. At AmeriVet Securities, one of our colleagues has been called up from the reserves to active duty and we wish him the best as he joins the fight against the virus.
It is unfortunate, but true, that we are forced to now deal with a health, financial and economic crisis, simultaneously. There is a long history of dialogue in the U.S. around pandemic and preparedness over multiple administrations and political parties. As the President decides to cut off funding to the World Health Organization and Congress debates the funding of more aid to small businesses, individuals, municipalities and hospitals, the reopening of the global economy will be less than a straight line.
There should be little doubt as the political landscape for November?s election shapes up, finger pointing from both political parties will be a larger and unfortunate part of the discussion. We mention it, because with it brings a dynamic that potentially and likely makes the reopening of the economy more challenging.
Most importantly now, the amount of resources being dedicated toward a vaccine and therapeutic options is enormous. At the same time in the short term, as the dialogue moves quickly toward reopening, rapid diagnostic and antibody testing (understanding) is moving along but slower than needed in critical areas. And not just to have testing, but the ability for scale with quality in results across the country and with attention to states hit the hardest. Broad based and accurate testing will require, like the need for ventilators, coordination between the federal government and individual states. We are fighting a crisis of health, but also the fear of the unknown. This economy will reopen in phases.
Financial Liquidity Markets
We have written at length about the infiltration and role the Federal Reserve is playing in this crisis. It?s controversial and in many ways, unavoidable, given the deterioration in liquidity conditions, unlike anything we?ve seen. With the fiscal side still contentious, fragmented and slow moving, the Federal Reserve?s options were limited in our view. The scale and scope are open for debate. For now, the Federal Reserve has acted decisively and broadly, and will continue to do so to support the U.S. consumer and economy. There will almost certainly be more programs and changes to existing ones ahead. ?
Federal Reserve Vice Chairman Richard Clarida stated earlier this week:
?I think moral hazard in past circumstances, when it?s been associated with financial excesses or private sector excesses, is obviously something to assess and think about, but in this case, is an entirely exogenous event. Businesses aren?t closing and people aren?t unemployed due to any fault of their own. And I think this is a clear as possible case that those aren?t relevant considerations.?
There are many that vehemently disagree with the statement above. The distinct notion that it was global central bank policies coming out of the crisis in 2008 which took valuations and volatility to extreme levels heading into 2020. In many ways, there is validity in that argument when looking at the global valuations in equities, credit, negative rates and volatility before the crisis hit. We highlight Clarida?s statement because it encapsulates a very important point regarding the Federal Reserve?s stance: the reason we are in this position matters more than valuations; that reason is not anyone?s fault.
The Federal Reserve?s actions to date have been astounding. Since the beginning of March, their overall balance sheet is up over $2 trillion, with half of that number coming with the purchases of Treasuries and mortgage-backed securities. In looking at the numbers from March to April, we prefer to look at both the asset and liability side of the equation to better understand the intention of the Federal Reserve through various programs and purchases.
It?s important within the context of the current crisis to have perspective. In many ways, we view this as 2001, 2008 and then some, all bundled up in one. With that said, many of the programs, albeit larger in scope and scale from the Federal Reserve, mirror that of the crisis in 2008. We reference then-Chairman Ben Bernanke in analyzing the current levels within the Fed?s balance sheet (as of April 8).
October 8, 2009
The Federal Reserve’s balance sheet: an update
Chairman Ben S. Bernanke, at the Federal Reserve Board Conference on key developments on monetary policy in Washington, D.C.
?Large increases in bank reserves brought about through central bank loans or purchases of securities are a characteristic feature of the unconventional policy approach known as quantitative easing. The idea behind quantitative easing is to provide banks with substantial excess liquidity in the hope that they will choose to use some part of that liquidity to make loans or buy other assets. Such purchases should in principle both raise asset prices and increase the growth of broad measures of money, which may in turn induce households and businesses to buy nonmoney assets or to spend more on goods and services.
On April 9, in conjunction with the CARES Act, the Federal Reserve furthered its activities in regard to financial markets, credit, lending and liquidity, with the unleashing of $195 out of $450 billion in capital levered toward a total program worth $2.3 trillion. Some of these programs were already in existence from earlier weeks (primary and secondary IG credit), while other lending facilities toward middle market corporate and municipalities were new.
The Federal Reserve Board Chair Jerome H. Powell stated on April 9:
“Our country’s highest priority must be to address this public health crisis, providing care for the ill and limiting the further spread of the virus. The Fed’s role is to provide as much relief and stability as we can during this period of constrained economic activity, and our actions today will help ensure that the eventual recovery is as vigorous as possible.”
A look at the Credit and Lending Program?s individual components
- Bolster the effectiveness of the SBA Paycheck Protection Program (PPP) by supplying liquidity to participating financial institutions through term financing backed by PPP loans to small businesses. The PPP provides loans to small businesses so that they can keep their workers on the payroll. The Paycheck Protection Program Liquidity Facility (PPPLF) will extend credit to eligible financial institutions that originate PPP loans, taking the loans as collateral at face value.
- Ensure credit flows to small and mid-sized businesses with the purchase of up to $600 billion in loans through the Main Street Lending Program. The Department of the Treasury, using funding from the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) will provide $75 billion in equity to the facility. Leverage will be 8:1, loans inside of 4 years, middle market companies with employees up to 10,000, SOFR+250-400, Banks retain 5% of the loans Pari Passu, worker retention clauses and restrictions on buybacks and dividends.
- Increase the flow of credit to households and businesses through capital markets, by expanding the size and scope of the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF) as well as the Term Asset-Backed Securities Loan Facility (TALF). These three programs will now support up to $850 billion in credit backed by $85 billion in credit protection provided by the Treasury. Leverage will be 10:1 for investment grade and anywhere from 3/7:1 for slightly below investment grade. The split between credit and TALF will be $750/$100 billion and TALF collateral will include CMBS and Leveraged Loans.
- Help state and local governments manage cash flow stresses caused by the Coronavirus pandemic by establishing a Municipal Liquidity Facility that will offer up to $500 billion in lending to states and municipalities. The Treasury will provide $35 billion of credit protection to the Federal Reserve for the Municipal Liquidity Facility using funds appropriated by the CARES Act. The lending will be with municipalities greater than 2 million residents with states being able to direct funds locally. The eligible collateral will be two years and under including tax, revenue and bond anticipation notes. The Federal Reserve also indicated they were watching primary and secondary municipal markets closely ? sounds like more to come with the municipal market.
The Federal Reserve has been very clear from the start in regard to the potential impact of the coronavirus as it spread: a clear focus on credit and its availability and proper functioning. When high quality credit markets began to freeze up in March, the Federal Reserve was very quick to utilize some of the playbook from 2008 to thwart deteriorating condition. So far, in many cases, it has worked. Long term implications left for another day.
We?ve been clear: we do see some characteristics within this period that are like 2008, with one of the main differences being the starting point. What began on the banking side in 2008 moved to Main Street, now in 2020 is working from the opposite direction. Main Street, municipalities, medium and small businesses have been hit extremely hard from the start, with the Federal Reserve leaning on the big, medium and smaller community banks for help with their lending and credit programs to help Main Street through the crisis.
Ben Bernanke, stated in October 2008:
?Although the Federal Reserve’s approach also entails substantial increases in bank liquidity, it is motivated less by the desire to increase the liabilities of the Federal Reserve than by the need to address dysfunction in specific credit markets through the types of programs I have discussed. For lack of a better term, I have called this approach ?credit easing.? In a credit easing regime, policies are tied more closely to the asset side of the balance sheet than the liability side, and the effectiveness of policy support is measured by indicators of market functioning, such as interest rate spreads, volatility and market liquidity.?
Beginning with a focus on repo market liquidity and expanding into Treasuries, mortgages, commercial paper, money markets, investment grade credit, municipalities and middle market lending, the Federal Reserve has been intent on improving market liquidity, functioning and overall funding levels. Unlike in 2008 when many of these markets completely shut down, despite a repricing in spread and credit levels, clients have been able to issue in the market and certainly fund inventory with volatility declining across Treasuries and credit within this period of time. ?
As many market participants welcome the Federal Reserve additional tools as necessary, many still contemplate the magnitude and degree to which market dynamics change indefinitely: the lines between private capital and the government disappearing across just about every asset class. Despite this, it seems prudent as we experience credit downgrades and the economic reality of this very dynamic crisis, keeping investments higher in quality assets for now and consistent with the Federal Reserve?s programs appears prudent. It?s by no means a panacea. How things evolve down the road with many of these programs remains uncertain, but history helps to provide context:
Former Fed Chairman Bernanke 2008 vs. Chairman Powell 2020 side by side
Bernanke 2008, Washington
The Federal Reserve?s exit strategy
?My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. Looking at the Federal Reserve?s balance sheet is useful, once again, in helping to understand key elements of the Federal Reserve?s exit strategy from its current policies.?
Powell 2020, Washington
?Our emergency measures are reserved for truly rare circumstances, such as those we face today. When the economy is well on its way back to recovery, and private markets and institutions are once again able to perform their vital functions of channeling credit and supporting economic growth, we will put these emergency tools away.?
With progress on the virus, the reopening of the economy is front and center. If you listen very closely, the overriding theme is caution. In the end, health will not be the exclusive factor of how we proceed, but it will play a large role. There are, and will be, differences of opinion in the weeks ahead which will complicate economic dynamics.
We expect the reopening to be economically uneven. There has been much discussion about the V-shape recovery and certainly markets have performed along those lines lately. We should continue to get used to the disparity between market performance and economic reality at times. This is not a new concept over the past 10 years.
Just like the last week and a half, the markets will find a way to gravitate toward different elements of this crisis: health, financial liquidity/markets and the economy. They are certainly not mutually exclusive, feeding off each other differently at times. Of late, and since March 23, markets have been more focused on progress, with the virus in conjunction with the Federal Reserve liquidity programs.
Short term, as we work through the economic data and earnings season, deciphering data and information will be difficult. Clearly, when looking at the bank earnings and credit loss reserves so far, concerns about the economy moving forward are real and taking precautions seem prudent.
For us, we continue to focus on the jobs side of the equation and the weekly claims numbers. To that end the data has been clear, but the message across the board has been mixed, dramatic and at times extreme all within the period of a month from out elected and appointed officials. ?Perhaps a sign of the times when looking at markets from March through April, but balanced management of this crisis will be needed along with cautious optimism.
Objectively, for example, the St. Louis Federal Reserve President James Bullard, within the course of a month, was calling for an unemployment rate ?potentially? as high as 30%, while offering no reason a V-shape recovery can?t happen.
?There is no reason it can?t come back in a V-shape? stated Bullard. ?I know it?s become popular to say that is not going to happen. I think it can happen.?
Will these employment claims reverse in the second half of the year? The trajectory still appears early stages in the opposite direction for the foreseeable future. Will the loan money be a magic pill? It seems unlikely. ?
As we continue to work through the Payment Protection Plan (PPP) and emergency loan programs (unemployment insurance, money to states, hospitals and individuals), timing is critical. We have been vocal; this is liquidity, not stimulus and less than two weeks into the PPP program, the administration and Congress are locked in a discussion for more money with programs that have been earmarked as broke at this point. ?
Unfortunately, in the coming weeks, millions more jobs will be lost.? It is truly tragic in so many ways, but also the reality of this unprecedented global crisis. So many more will be furloughed and left with uncertainty.
The flow of funds to individuals and businesses is now happening, which is good, but likely already spent and accounted for. This all makes the ?timing? and ?demand? side with consumer behavior extremely critical versus available liquidity.
Within that context, we remain cautiously optimist, but very pragmatic as the reopening could very well disappoint, creating a continued tug of war between monetary and fiscal policy liquidity versus economic reality in the months ahead.