The vast and currently dysfunctional markets for US Treasuries, mortgages and corporate credit now have the ultimate buyer of last resort — the Federal Reserve.
Ever since the big stock market crash of 1987, investors have grown to depend on the US central bank coming to the aid of financial markets when they hit the skids. Now the central bank is well and truly “all in”, announcing a slew of new initiatives on Monday designed to buy time for an enfeebled financial system. Until now, the Fed implied, the system has been in no shape to withstand an escalating pandemic that has the US economy facing the biggest hit to growth since the 1930s.
Having failed to ease nerves over the past week with an expansion of its quantitative easing programme, the Fed has upped the ante to Buzz Lightyear territory. “QE infinity,” in the form of unlimited buying of Treasury debt and mortgage-backed securities, is just one aspect of the new approach.
Another notable measure is the Fed’s entry into the universe of investment-grade credit, with the central bank launching a facility that will enable the purchase of corporate debt that has already been sold with a maturity of less than five years, and also of exchange traded funds that track the sector. Yet another facility will support new sales of bonds and loans from companies with investment-grade credit ratings. One way of looking at this is to note that the Fed has joined the Bank of Japan, the European Central Bank and the Bank of England in supporting credit markets. Viewed another way, it complicates any future exit strategy and extends a long post-Lehman crisis legacy of distorted risk premia in markets.
But perhaps now is not the time to quibble over legacies, while the pandemic rages. The purchase of corporate debt by the Fed is designed to prevent a deeper and prolonged bust facing an economy that has been placed in suspended animation. A highly indebted US corporate sector, fuelled by Fed policy objectives since the last crisis, is being stripped of earnings growth and cash flows for an indeterminate period. This is led by companies operating in the travel, leisure, restaurant and retail sectors, and sets the stage for a deepening of the current macro economic shock.
Credit risk premia have moved sharply wider in recent weeks, catching out many investors, while also preventing lower quality borrowers from refinancing their maturing debts in the form of commercial paper and corporate bonds. Losses for many fund managers are mounting, while exchange traded funds have become highly volatile and dysfunctional. In the US Treasuries market, meanwhile, when liquidity dries up, conditions for corporate credit become even more stressed, intensifying a fire-sale environment as investors rush for exits and seek to cash out at any price.
An aggressive expansion of QE by the Fed has loomed large since the eruption of market turmoil just over a month ago. Some have long argued that unlimited quantitative easing was a likely final step, after the policy appeared to become a permanent feature of the Fed’s toolkit in the wake of the financial crisis.
The policy of suppressing long-dated Treasury yields — and by extension, broader market volatility — was billed as a temporary measure when introduced in 2009. But it has pretty much become business as usual since then for the Fed and other leading central banks. Efforts by the Fed to raise interest rates by modest amounts, and to trim the balance sheet, were terminated after severe market turmoil erupted in late 2018, casting a lengthy shadow over business and consumer confidence. A financial system replete with debt was in no fit state to handle even a slight rise in Treasury yields back then.
Now, an even more indebted corporate sector faces intense pressure — until a peak in the spread of infections allows the economy to start rebounding, unblocking cash flows and boosting earnings to some degree. The ultra-low borrowing costs of recent years provided companies with licence to tap credit markets to fund expansive share buyback programmes that benefited executives. The failure to save for a rainy day means many companies are now holding out for help from the taxpayer.
The Fed’s new set of measures also means that the central bank’s balance sheet will increase markedly in size as it becomes ensconced as the buyer of last resort across fixed-income markets. Investors should not expect any contraction any time soon, given the scale of the debt binge since 2009.
And they should not rule out further support measures, should markets remain treacherous and hard to trade. While the Fed’s intervention boosted some areas of the US credit market on Monday, stocks were muted, reflecting the other game in town — negotiations over a $2tn fiscal response to the economic effects of the health crisis.