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Fed firefighters must act quickly to limit financial contagion

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Via Financial Times

A major financial market liquidation event is now upon us and looms as quite a epitaph on 11 years of easy money and aggressive risk-taking.

Shocks continue to ripple through the financial system, with the US suspension of travel from Europe the latest trigger for indiscriminate selling across markets. Leading equity markets fell about 10 per cent on Thursday while Wall Street briefly suspended trading just after it began. This no longer reflects investors trying to assess the likelihood of a recession and the ensuing hit to corporate earnings over the coming quarters.

In a void created by the lack of global co-operation among policy officials and governments, risk management models are now running the show for the financial system. The message is loud and clear: investors and trading firms are cleaning up their balance sheets. This stops markets acting in a smooth and orderly manner and the hit to liquidity comes at the worst possible time.

Getting out of lossmaking trades and cutting exposure is the sole mantra at the moment. Selling into declining markets creates a fire sale environment: across futures, cash equities and bonds, and through exchange traded funds and derivatives, the exit trade dominates investment behaviour. Emerging markets and corporate debt are under intense pressure, as befits their status as riskier areas of financial markets. The current mood chimes with strains not seen since the worst periods of the financial crisis in 2008.

“Markets remain in a very vulnerable state and the selling has resumed in earnest. It’s about risk reduction and raising cash,” said Brad Bechtel, strategist at Jefferies.

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A notable sign of liquidity pressure in markets is when areas that have performed well, such as gold and government bonds, endure sudden bouts of selling. This suggests that investors are selling their “winners” in order to raise cash to cover losses in other parts of their portfolios.

Even in the huge US Treasury debt market, the ability to buy and sell paper has sharply deteriorated, according to dealers. Constant trading activity between Treasuries, futures and interest rate swaps helps maintain a balance within the world’s largest government bond and fixed income universe. But those relationships have broken down. Playing an important role here are hedge funds and other investors that buy and sell between different interest rate sectors, using borrowed money to bolster their returns.

In the present climate of a liquidity shock and broad risk reduction, losses are mounting. This was also the outcome during previous episodes of intense market turmoil, as seen in 2008; in the wake of the September 11 2001 terror attacks; and when the hedge fund Long Term Capital Management collapsed in 1998.

When US Treasury market liquidity becomes impaired, strong action from the Federal Reserve usually arrives. The US Treasury regularly sells vast amounts of debt each month to finance a rising budget deficit, and that requires an orderly functioning market to absorb such sales. In early 2009, the Fed announced purchases of Treasury debt, or quantitative easing, in order to calm market conditions in the bond market.

This explains market expectations that the central bank will soon slash overnight rates towards zero. The prospect of the central bank buying Treasuries beyond its current menu of short dated bills appears very likely.

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The challenge facing officials and investors is that the current turmoil reflects years of investors pushing further into risky and less liquid areas of the financial system in search of returns.

Beyond the damage inflicted by major western economies self-isolating as Covid-19 spreads, intensifying market turmoil also impairs business and consumer confidence, making the task of eventual recovery far tougher and longer. The firefighters at the New York Fed need to scramble if they are to contain financial contagion.

michael.mackenzie@ft.com

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