The moment when monetary ‘shock and awe’ finally fails has arrived: what do we do next?
Ambrose Evans Pritchard, The Daily Telegraph.
The world’s central banks have exhausted almost all their usable ammunition under existing rules yet still failed to calm markets or to unfreeze critical parts of the global financial system.
This moment what we all feared. The danger now is that global recession – it is no longer "if", we are weeks into it already – will morph into something more intractable: a deflationary depression with a wave of defaults that breaks the capitalist system as we know it.
So what can be done? Let me take an instant stab. Either the rules are changed fast or we risk uncontrolled global liquidation. The US Federal Reserve must be unshackled to act as a buyer-of-last-resort for the corporate debt markets, for great swaths of the credit system, and for Wall Street equity indexes.
The European Central Bank must acquire powers to act as a genuine lender-of-last resort for eurozone sovereign states. It must do exactly what Christine Lagarde refused to do when she blurted out last week that “the ECB is not here to close bond spreads” – an expression lifted word for word from the German board member, Isabel Schnabel, which tells us who is in charge of that institution in the post Draghi era.
This must be backed by a fiscal blitz even greater than in 2008-09, with pledges to “socialise” the drastic losses faced by industry and private firms. What was done for banks last time despite misconduct must now be done for others. There must be tax holidays, sweeping state guarantees for firms, credit forbearance, a temporary suspension of mortgage payments (pushing out the maturity), and moral hazard be damned – all under the umbrella of financial repression.
Both the US and the EU need fiscal New Deal packages near $1.5 trillion between them to launch recovery, much like the Schumer plan in the US, and in Europe’s case funded collectively through eurobonds.
What has happened over recent days is not a matter of panic. It is accurate market pricing of ‘sudden stops’ across all major blocs. It reflects the collapse in earnings and the spread of insolvency risk. It is a rational response to the self-evident lack of coherent political leadership or a functioning G20 world community that is capable of containing either Covid-19 or the economic chain-reaction that might unfold.
As a result, forced sales are occurring on a huge scale across interlinked markets for mechanical reasons. The pandemic has shown that the supposedly-safe structure built by regulators after the Lehman meltdown is a Maginot Line. Critics warned that this would happen when the next black swan arrived.
As a recent report for the G20 put it: “the risk of an unexpected reversal of abundant global liquidity hangs over the world economy. Strong contagion across markets could make the endogenous dynamics of global liquidity very dangerous.” Did anybody heed the warning? No.
Europe will discover quickly – perhaps within days – that the sticker-plaster job by EU leaders after the EMU debt crisis has resolved nothing. The failure to establish some form of fiscal union during the Draghi reprieve leaves the euro system exposed to the sovereign bank "doom loop" of 2011-12. In key respects it is even more toxic today.
The Fed did only half the job on Sunday night with its emergency cut of 100 basis points and its plan for $700bn of QE over the next six months. But we are getting there. The measures should (fingers crossed) prevent a repeat of the frightening moves that we saw in US treasury yields on Friday.
We know roughly what happened. The "relative value" trade in the Treasury market so favoured by hedge funds blew up and caused a cascade of deleveraging. These funds buy cash bonds while selling offsetting futures to pocket the arbitrage gain. Margins are wafer thin so they leverage up. It is easy money until the normal correlations go haywire.
The US Treasury market is the anchor of the global financial system. It cannot break down without causing everything, everywhere, to unravel. That is what we faced going into the weekend.
The Fed has defused another dangerous landmine by renewing dollar bank swap lines to fellow central banks. These FX lines are what saved the European banking system in 2008 when wholesale capital markets froze and Europe ran out of dollars.
Only the Fed can print US currency and act as the superpower backstop for the world’s dollarised financial system. Nobody was sure whether they still existed in Donald Trump’s Washington. Now we know they do.
What the Fed has not done yet is to shore up markets for commercial paper, certificates of deposit, and other parts of the credit system. It has not so far offered limitless cheap loans through the TAF term auction facility. “We have nothing to announce on direct lending,” said Fed chief Jay Powell. The markets did not like the sound of that.
Some measures require changes in US law. Treasury Secretary Steve Mnuchin said over the weekend that he would seek to revive the Fed’s suspended emergency powers. “Certain tools were taken away that I’m going to go back to Congress, and ask for,” he said.
The Fed’s hands are tied for now. A puritanical bank-bashing Congress stripped the institution of key prerogatives after the Lehman crisis. The Fed can no longer rescue a single bank in trouble (there must be at least five). Nor can it issue blanket guarantees of bank debt and money market funds, or issue instant loans to stem stress in commercial paper and asset-backed securities.
In my view, Congress will have to go even further and let the Fed buy company bonds, ETFs, and other private assets, as the ECB or the Bank of Japan are allowed to do. In extremis, the Fed may have to soak up some of the $3.4 trillion tranche of BBB-rated bonds perched precariously above junk and at risk of a roll-over funding shock.
This would compress spreads and help head off a credit crunch. The Fed could in theory go down the rating ladder and do whatever it takes – all the way to junk if necessary. The line is arbitrary.
Will any of this happen? Yes, because the American political class has woken up to the potential disaster coming their way. Donald Trump likes fiscal and monetary largesse. He will not hesitate.
Europe is another matter. The EU fiscal package so far is less than 0.3pc of GDP. This does not move the macroeconomic needle. Nor does the ECB’s extra bond purchases of €120bn, spread over nine months, a tiny fraction of what the US is doing.
Brussels is to activate an emergency clause allowing governments to breach the Stability Pact and spend more to fight the coronavirus. That is wholly inadequate.
The most vulnerable states are being left to fend for themselves. They happen to be Italy and Spain, both now in the grip of hair-raising lockdowns; as well as Portugal and Greece, with double-digit reliance on tourism. The old ‘PIGS’ are being thrown under the bus again.
The eurozone should be careful. The surge in peripheral risk spreads last week hit the semi-core and even France. There were signs that markets were once again trading EMU break-up risk.
“An every-man-for-himself approach will not be enough to stabilise the eurozone. We think it requires pooling of balance sheets,” said Evercore ISI.
Yes, Germany is issuing credit guarantees of up to €550bn through the state-owned KfW development bank to shore up the country’s industrial machine, if need be.
But what about Italy? Its economy has all but collapsed. Its debt ratio could be nearing 145% of GDP by the end of the year. There are ever louder warnings that it will need a massive rescue from the eurozone bail-out fund (ESM), which would require the approval of the German Bundestag and the Dutch Tweede Kamer, and turn into a political nightmare.
This structure is untenable. Either Germany and the northern creditor states bite the bullet and agree to debt pooling, joint bond issuance, fiscal integration, and a pan-EMU bank deposit insurance – with all this implies for the evisceration of parliamentary democracy in Europe’s nation states – or world markets will again lose faith in the viability of monetary union.
They do not have long to make up their minds.