Covid-19 has led to a hysteria that’s had big psychological impacts and developed into a widespread crisis of confidence. It’s bled into not only economic activity in a material way, but also future expectations of economic activity. Future expectations and how they’re discounted is what the markets care about.
Where the coronavirus could go, how many it infects, and what the ultimate fatality rate and total will be has a wide distribution of outcomes. The top experts in the field of epidemiology, virology, and immunology also don’t know the ultimate outcome.
What policymakers can do
At the same time, the traditional policy tools used to counteract a downturn are no longer there. Moreover, the need for elected political leaders from both sides to work with each other and with central bankers to bring about a coordinated solution is high, but nonetheless unlikely.
The last recession in 2008 was bad, but in the US, the Federal Reserve had the luxury of being able to cut interest rates from over 5 percent at the front-end of the curve. Now we’re going into the Covid-19 related downturn at zero. (Technically, we’re not yet at zero as this is written, but it’s already discounted into the market.)
Keeping rates low helps prop up asset markets, whose cash flows are priced on the discount rate. This is heavily dictated by the cash rate. At the same time, liquidity and credit risk premiums have expanded out due to widespread fear and the lack of clarity over how bad the health and economic outcomes will get.
So, cutting rates won’t be effective. They can go negative, which the Fed has up to this point said they wouldn’t do. It would make cash a little bit less attractive. But it has a limited effect in getting more people out of cash into risk assets. The marginal benefit of going negative is small and whether it provides any benefit at all is not a black-and-white answer. People still need to save and they still need access to liquid, safe assets. Lenders also need to be cautious in the types of deals they do.
Quantitative easing – a secondary form of policy which central banks turn to when rate policy has run out of room – has much less potential, given where bond rates are. When those spreads are also at zero, then you’ve run out of room.
So the prospect of simply lowering rates and buying assets – the traditional wind to the back to boost up asset prices – is no longer there.
Tertiary policy options
Ultimately, what transpires, where the bottom is, and where asset prices go from here will depend on the discounted expectations of what fiscal and monetary policymakers do.
Extension of quantitative easing (QE)
The Fed can currently buy US Treasury bonds and government-sponsored mortgage backed securities (MBS).
The European Central Bank can go beyond that and buy certain forms of investment-grade corporate credit.
The Bank of Japan can buy exchange-traded funds (ETFs), or can essentially buy equities in some form.
The Fed buying MBS could help further lower mortgage rates. That would help incentivize new refinancing activity to lower monthly mortgage payments to put more money back in the pocket of consumers to help spending. It would also help pull in new borrowers to incentivize greater credit creation and transaction activity. Real estate is also a significant part of the wealth of the US middle class and could help benefit “workers” to a larger extent than traditional asset buying programs, which mostly benefit the upper class who own most of the stocks and business equity.
The graphic below shows how the portfolio between the bottom 50 percent and top 1 percent of households allocate their assets:
If the Fed were to participate in buying assets further up the risk ladder like corporate debt or even equities, it would help boost their prices. But to what extent this would help finance spending in the real economy is debatable.
The health of the capital markets are absolutely essential for the broader health of the economy because it is the financial system that provides the money and credit that feeds into spending and investment. But central banks printing money to buy riskier assets than they have done in the past may not be superior relative to other targeted approaches and policy options.
Yield curve control (YCC)
Going forward, the Fed is probably going to institute some form of yield curve control, which Japan implemented in September 2016. The US also previously used this approach in some form in the 1942-47 period to control war funding costs.
But this probably won’t have much effect. The way it basically works is to keep a positive slope to the yield curve to keep lending spreads positive and encourage credit creation from lenders.
The central bank sets a cash rate and then sets rates further out on the curve, such as the 10-year yield, higher. If the longer-term rate falls below a certain threshold (or goes above, as higher rates are also not wanted), then the central bank can come in and defend the band by buying and selling that maturity as appropriate.
There’s also the option of debt monetization where the Fed essentially pays for the deficits created by the federal government. The Fed can essentially “print money” and use it to pay for the debt.
The effect of this policy goes through the currency channel. This would mean a weaker USD. A weaker currency helps relieve debtors. When there is a lot of debt relative to income, as we have now, policymakers will inevitably have to favor the debtors. This is particularly true when there’s a shock that impacts economic activity (Covid-19, plus the oil shock which has gotten buried underneath the various virus-related headlines).
This is worse than the alternative of taking it through the interest rate channel. A larger issuance of debt to the public raises rates. The economy isn’t strong enough to handle that. As a matter of necessity, nominal interest rates must be kept below nominal growth rates to keep debt from compounding faster than the economy can grow.
The US is also in a situation where a lot of debt is going to need to be rolled over in the next few years, up to 25 percent of national output (i.e., GDP). At the same time, the US is already running deficits of about 5 percent of GDP. In the next downturn that could easily blow out to double that.
To plug those funding gaps, that means selling a lot of bonds. The private demand from domestic and foreign sources won’t be there.
Your number one rule for tracking global financial flows: foreign demand for US Treasuries is a function of global reserve growth. The absence of strong foreign demand for US Treasuries over the past few years hasn’t been hard to explain – reserves haven’t been growing.
Now to go along with an increasing surge in new issuance, there’s no way for foreign demand to sop this up. Private domestic demand will be weak.
This means it will be on the Federal Reserve to recognize this and act accordingly. You’ll either have a hiccup in the bond market if the Fed doesn’t buy this new supply of bonds fast enough – i.e., yields up, prices down – or you’ll see the Fed “print money” (bad for the USD) and put all those bonds on its balance sheet (or monetize the debt directly).
At the same time, other developed markets have similar types of issues. And this doesn’t include just the headline debt figure, which is the accumulation of net spending in excess of net revenue intake. Over the coming years, due to aging demographics, non-debt obligations like healthcare, pensions, and other unfunded liabilities will come increasingly due. Depending on the discount rate used if these obligations were to be capitalized, they are over 10x the size of the headline debt figure, which currently stands at around $23 trillion in the US.
What is likely to happen is that the US dollar will depreciate in relation to a hard reserve asset like gold. Gold has traditionally been a reserve currency, and is basically the inverse of money, with its long-run price proportional to fiat reserves and currency in circulation relative to the global gold supply. The global gold stock tends to grow by only about 1-3 percent per year. Obligations coming due will be well in excess of that.
This is not a recommendation to buy “a lot” of gold or an insinuation that its price will go up in the near-future. It’s a long-run expectation that gold has positive secular forces going in its favor. Having a small portion of one’s portfolio in gold can be a good idea.
But gold also has its own set of issues, such as the fact that it’s a relatively illiquid market – about $3 trillion of gold above a certain level of purity, compared to equity markets of about $75 trillion (which is fluctuating a lot on a daily level) and credit markets that are almost $300 trillion deep. So, gold lacks the capacity to accept big inflows of wealth from equity and credit markets. At the same time, if such a move were to happen the market’s relative illiquidity could help move its price in a material way.
Gold is simply an alternative currency that can be part of a balanced portfolio that is well-diversified among different asset classes, countries, and currencies. We explained how to go about this process in the article ‘How to Build a Balanced Portfolio’.
There is also the prospect of “helicopter money” where the Fed can put money in the hands of savers and tie it to spending incentives, such as having as money disappear if not spent after a certain period of time.
The central bank in the US is not legally permitted to do this. For helicopter money, the government have to change the laws or devise a scheme to get around it, such as the federal government depositing non-transferable, non-redeemable, zero-coupon bonds with the central bank (which essentially have no value).
Such a program would better target spenders and remove the constraints associated with the bond market.
More broadly helicopter money can be taken as any program of spending and consumption support without having it tied to borrowing. Namely, governments may need to break the linkage between spending and borrowing as it’s currently done.
In traditional monetary policy, short-term rates are your constraining force. When that’s maxed out, then you move onto buying bonds (quantitative easing). So then the bond market becomes the constraining force. Once that’s out of gas with bond yield at zero or a bit below, then you have to move onto something else.
In other words, you have to get around the bond market being your barrier.
That means you have to move on to a program such as the central bank capping the cost of capital. This would allow the government to borrow money, as needed, that can’t exceed beyond a certain yield (similar to yield curve control).
This is a type of function that can allow central banks to directly fund projects and government spending. Moreover, it effectively breaks the linkage between spending and borrowing.
Longer-term this will lead to an increasing merger between monetary and fiscal policies and a policy framework that is largely independent of the bond markets. This can also be done without compromising the independence of the central bank, such that it’s not subject to the often short-term political goals of elected leaders.
If you think a policy like this will weaken the currency, then you’d be absolutely correct. It’s not “free”. It will not necessarily weaken one currency relative to another depending on how the capital flows work out, which can also be contained via a Plaza Accord style agreement or through restrictions. But it is quite likely to weaken the currency, over the long-run, relative to a hard alternative money asset like gold.
The Problem in the Asset Markets
Stocks have gotten hammered by more than 30 percent peak to trough.
Earnings are going to take the biggest hit since the 2008 financial crisis. Earnings growth has already been reported too high due to widespread creative accounting practices (i.e., GAAP compared to what we see in the national-level data) and US earnings growth was over-extrapolated when secular forces were weighing against further margin expansion.
The Valuation Question
The selling that’s been taking place has been in excess of what’s warranted on the basis of fundamentals. Investors are largely getting knocked out of positions due to cash flow problems, not because the fundamentals are deteriorating at the rapid pace if directly implied from movements in asset markets.
Is world business worth 30 percent less than it was a few weeks ago? Some of it is a drop in earnings expectations – less cash flow that makes financial assets worth what they’re worth – and some of it is a function of a rise in risk premiums. Due to the extra volatility more people want to be compensated for taking on risk.
This could mean somewhere between a 70 percent drop in earnings expectations relative to what we had before (unlikely). Or it could mean investors now want to be compensated an extra 3.5 percent per year for taking on equity risk relative to owning cash or safe bonds (also unlikely).
It’s probably somewhere in between. For example, it could mean a 35 percent expected drop in earnings and investors expecting to be compensated an extra 1.75 percent per year for owning equities versus cash or bonds.
Investors’ cash flow issues
Investors are currently experiencing an issue where they were previously leveraged long in equities and other risk assets. They are now facing the consequences of the decisions they felt comfortable making in more tranquil times.
When volatility is low, this usually means equity markets are in a healthy place, where their valuations are relatively high and thus have lower forward returns.
To compensate and magnify lower future returns into the returns they’d like, they take on more leverage.
When a shock hits the system, they get shaken out. They need to sell in order to meet margin requirements. This causes markets to go down further. This amplifies further selling, and so forth. It can lead to a dangerous feedback loop if not reined in.
When people need cash, they sell. This includes anything. Even gold, normally considered a safe haven, is down. The Japanese yen is up because it’s a popular carry currency. Investors use it to fund trades cheaply. When risk asset markets go down, this leads to a short covering in yen.
In the beginning of the market downturn, US Treasury bond helped provide an offset to falling stock prices. Now, those bonds aren’t doing as well. On “Black Thursday (2020)” (there’s a Wikipedia page dedicated to it) bond prices actually fell along with stocks.
This is a problem because it signals a lack of cash in the system.
It is doubly a problem because the Fed and other central banks have limited tools.
The capitalist system is predicated on financial assets outperforming cash. The economy can’t work very well for any elongated period when this isn’t true.
That means central banks and lawmakers will have to take coordinated action to get the system going again.
Going down to zero rates on the front-end of the rates curve is a no-brainer and will become official very soon. QE is a possibility, including expanding it, but is almost out of room.
Tertiary forms of monetary policy will need to be put into gear, but they’re not yet ready.
The Fed has used repo injections, but those won’t have much impact. Repo is important for maintaining the health of overnight lending markets, but doesn’t make a material difference in asset markets or the real economy (assuming it’s temporary).
Short sale restrictions, which Italian politicians have called for, are commonly done when things get really bad. But they have the effect of making market liquidity even worse at a time when it’s most needed. (Liquidity is the ability to sell investments for cash.) A single share can be lent out multiple times. Short-selling is also an important component of the market-making business, for example, which plays a large role in keeping options markets and cash equity markets liquid. Short sale restrictions are often repealed quickly even though short-sellers are a common scapegoat for purportedly making a problem worse.
Moreover, at any given point in time, the amount of financial assets is a lot higher than the amount of money in circulation, usually by a factor of 15x or more.
When investors become unwilling to continue lending and borrowers need to come up with cash to cover their debt payments, liquidity becomes an issue. When you own a $10,000 bond, it is assumed that you will be able to exchange it for $10,000 worth of cash, which in turn can be used to buy $10,000 worth of goods and services.
However, because the creation of financial assets is easier than the production of goods and services, and thus the ratio of financial assets to money is high, the cash isn’t always available to convert these financial assets into money in bad times.
Accordingly, the central bank either needs to provide the liquidity that’s needed by printing money or allow a lot of defaults. Policymakers will always prefer to print because of the costs of not doing so are higher than costs of doing so (i.e., deprecation of the currency).
Coronavirus set off a shock that was already latent
We have iterated in previous articles that the risk/reward to risk markets was already asymmetrically skewed to the downside.
(i) The economy is heavily indebted relative to income
(ii) Monetary policy was (and now is) close to being out of room. Tertiary policy options aren’t yet in place. Interest rates, already being at zero at the front-end of the curve, is not going to be stimulative. It’s already priced into markets, and stocks continued to fall. Yields at zero further out along the curve won’t have much effect in bringing up asset prices.
(iii) The political bifurcation is large. There is conflict between political parties, who are more interested in butting heads than working together. And coordination between fiscal and monetary policymakers is also unlikely for the time being, though necessary in order to handle this type of downturn well.
Coronavirus has set off a crisis of confidence that brought all these problems to the surface in short order, and little time to react to them.
Since the financial crisis, the household sector has deleveraged as a whole. This measures and tracks debt payments as a percentage of disposable personal income over time.
(Source: Board of Governors of the Federal Reserve System (US))
But corporate leverage has been a different story. It has grown well in excess of income.
(Sources: BEA, Board of Governors)
The low interest rates since 2008 have fueled a corporate borrowing binge. The rate on debt has been low relative to the return on equity. This has boosted the incentive to engage in share buybacks, further pushing up the prices of equities.
But when the next downturn came, all this extra leverage in the system made companies susceptible to exacerbated shocks in their share prices. In the capital structure of a company, bondholders are senior to shareholders. This means in the event of a hypothetical liquidation bankruptcy, shareholders get paid last. A lot of debt means a lot of stakeholders in front of shareholders, adding more risk for them.
When companies run into a period where revenue declines, particularly when its unexpected and unplanned for, debt is coming due and rolling it over is difficult because lenders have pulled back and grown more cautious (both on the firm in question and out of broader systematic necessity), they have a problem.
This extra leverage has fueled a decline in the stock market that has been among the steepest ever. The trajectory is shown below in comparison to the crashes of 1929, 1987, and 2008:
In normal times, having corporate debt as ~47 percent of GDP might not be a bad thing if the rates on it are sufficiently low and the maturities are spread out (or it can be refinanced easily) such that it’s not a problem.
But when things head south and there’s a drop in revenue, all of that debt can become a huge problem.
What’s required going forward
Handling shocks when interest rates can’t be lowered to relieve debt pressures and stimulate credit creation and when asset buying programs have mostly run their course, you need a new type of policy.
More of the onus will fall on fiscal policy and monetary policymakers will need to coordinate in order to support that.
People and businesses hardest hit by the virus will need to be provided financial assistance such as short-term bridge loans that help get them through the crisis. This is not a standard case of letting people and businesses wash out because of a lack of productivity or viability. The economic effects that have resulted from the virus are no different than those associated with a natural disaster.
The cost of not providing assistance is greater than the cost of not providing it, with the extent of such support on par with the extent of the crisis. When companies have to cut back on labor and default on their debts due to revenue losses, the economic problems and overall productivity in the economy can get much worse.
Assistance programs for counteracting the virus will come with the effect of raising the deficit. Moreover, holding all equal, this will also raise interest rates. In a highly indebted economy, letting interest rates rise is not recommended. The alternative is to print the money and monetize the debt.
While such a policy is controversial, it’s something that all of us in developed markets will need to get accustomed to as policymakers deal with monetary policy that’s out of gas in all the normal ways.
Will this crisis of confidence produce a recession?
It seems likely that the 11-year US expansion will come to an end.
Nevertheless, tracking the economy in real-time is challenging. The textbook definition of a recession is two consecutive quarters of economic contraction – i.e., growth below zero percent relative to the previous period.
Even in 2008, after the collapse of Lehman Brothers in mid-September of that year, there was still the question of whether the economy was in a recession or if it was just limited to “market turmoil”. In fact, the US economy was in retrospect determined to have entered recession back in December 2007.
It can takes months for a slowdown to show up in the data. GDP readings are lagging indicators of what’s already happened. They are also subject to revisions.
Most likely, a slowdown would first become visible in sentiment readings – i.e., business and consumer confidence – in claims for unemployment insurance benefits, and later in investment and spending data.
Stresses in the market are one of the last things to become apparent. In fact, labor market stress readings, such as unemployment often top after the next expansion is already underway.
(Source: US Bureau of Labor Statistics)
Private measures of recession will typically emerge the fastest, particularly in “soft data” like surveys, which provide data points about conditions before they show up in the actual numbers. The Morgan Stanley Business Conditions Index is one recent indicator.
In March, the survey, which includes a broad selection of industry analysts, fell close to the all-time low seen in November 2008.
(Source: Morgan Stanley)
Consumer confidence also began falling sharply shortly after the first confirmed US case of the coronavirus.
(Source: Morning Consult)
Goldman Sachs expects major cutbacks in various forms of consumption. Healthcare will see a boost, though certain industries will see a sizable hit to revenue. Sports and entertainment and vacation tours will see a near-total cancellation. Public transportations and gambling will see a major hit. Hotels, food services, car rentals, and domestic services will take an estimated 50 percent hit.
In total, the hit to GDP via consumption could total around 7 percent of GDP.