|Federal Reserve chair Jerome Powell|
Was it the Lehman moment?
The weekend of March 14-15 was without question a big one for global policy moves. Not only was there a second emergency rate cut from the Federal Reserve, but the US central bank also waived reserve requirements, lowered the cost of tapping its discount window, encouraged banks to their capital buffers to support the economy, and announced $700 billion of bond-buying. Alongside other central banks, it also cut the cost of dollar liquidity swap arrangements.
It was the return of the ‘Sunday Scaries’, as CreditSights analysts put it.
The moves followed the previous week’s ramping up of the European Central Bank’s bond-buying programme, the easing of capital and liquidity requirements in Europe and a big intervention by the Fed in the repo market as authorities and institutions tried to grapple with the global disruption of the coronavirus pandemic and the ramifications of a new oil-price war.
But all to no avail. On Monday markets melted. Some called it the coronavirus crash. Big US banks lost more than 15% of their value. The Dow Jones Industrial Average lost 13%. The FTSE100 fell 4%.
Surely, bankers said, this was ‘Capitulation Day’.
And so had they dared to hope on Tuesday, after a 5% strengthening in the Dow, a 2.8% recovery in the FTSE100 and improvements in some areas of the credit markets.
The day also saw more from the Fed, which announced a commercial paper funding facility (CPFF) that would buy unsecured and asset-backed CP, as well as a primary dealer credit facility (PDCF) that is offering 90-day loans.
“Extraordinary times require extraordinary action”
– Christine Lagarde, ECB
But by Wednesday night any hope looked as fanciful as ever, after another 6% rout in the Dow, taking it to a three-year low. The S&P500 lost 5%, but just held up above Monday’s level. But the FTSE fell 4%, plummeting to levels not seen for 10 years.
Across the world, the US dollar is the only currency anyone wants. Others are tanking; Norway’s krone, hit by the Covid-19 pandemic and the oil price collapse, has dropped 20% against the euro in two weeks.
Capitulation day is looking more and more like capitulation week, month or year.
The US and Europe fired a double-barrelled response on Wednesday night, hoping finally to give the support that corporates and markets have been crying out for.
The European Central Bank created a Pandemic Emergency Purchase Programme (PEPP), a €750 billion commitment to buy sovereign and corporate bonds that would remain in place for as long as needed. And in its strongest attempt to support day-to-day corporate funding, the bank said it would now buy non-financial CP.
“Extraordinary times require extraordinary action,” tweeted ECB president Christine Lagarde. “There are no limits to our commitment to the euro.”
Quite so. This was her Draghi whatever-it-takes moment. Just one week earlier Lagarde had been pilloried for her frank assessment that it was not the ECB’s job to help close government bond spreads, a comment interpreted as being aimed squarely at Italy.
|ECB president Christine Lagarde|
The US, meanwhile, unveiled hefty fiscal measures. The Senate approved a $105 billion coronavirus bill on Wednesday night that was focused on funding Covid-19 testing for all, as well as food assistance programmes.
Recent history is certainly not encouraging, but there were indications on Thursday that the newest measures were arresting at least some of the slide. European sovereign bonds perked up, particularly those of Italy and Spain, and spreads to German bunds tightened markedly. Stocks may have been hitting 10 year lows, but periphery government debt might yet see 10-year rallies.
Stocks also gained, the FTSE100 closing up 1.4% and the Dow up about the same amount as of early Thursday afternoon. Later that evening the Bank of England cut rates for a second time in two weeks, to 0.1%, and announced a £200 million increase in bond-buying, to £645 million.
Friday looked set to be a better day. A US market recovery may also have more scope after the eventual passing of an expected additional package of up to $1 trillion that is under discussion. It could see government money distributed directly to the population alongside massive help for small businesses.
A run on corporates
There will be many pivotal moments before this crisis has run its course. But Boeing’s draw-down over the last week of a $13.8 billion credit line that the aerospace firm obtained as recently as February will surely be recorded as one that cut to the very heart of the turmoil.
If the 2008 financial crisis was a run on banks, the coronavirus crash of 2020 is a run on corporates.
Banks are not in the clear though.
“This is the wake-up call,” one banker told Euromoney on Tuesday, as Boeing confirmed its full draw-down of the loan. “Banks are in a very different place to 2008 in terms of capitalization and liquidity, but this is exactly why they needed those buffers.”
If industries have not had their legs cut from under them by the demand shock caused by government actions to isolate large population groups, they have been hit by supply disorder. Retail and hospitality are merely among the most obvious sectors to be devastated. Airlines are grounding most flights and laying off staff: SAS is cutting as much as 90% of its workforce.
Knock-on impacts are emerging by the day. Analysts at CreditSights fear the exposure of some aircraft leasing names could be worse in Europe than it was in China, with the added challenge of the absence of a central body in the region to help put the sector back together again.
AerCap’s exposure to Air France and KLM is in the order of $2.2 billion; at Air Lease it is about $665 million.
On the supply side, automotive manufacturers are closing factories amid disruption to their supply chains. The downside of just-in-time efficiencies is being laid bare.
For the moment the focus has been on the first-order impacts of businesses having to close their doors as their customers hunker down at home. Loan forbearance by banks, supported by government policy, is spreading across Europe, although there is little expectation of the kind of blanket support seen in China.
But if markets remain repriced for a long time, a second-order issue will be that of corporate pension deficits, says one banker, noting that asset price collapses are big enough to make this relevant even in schemes weighted towards fixed income.
Speaking to bankers trying to battle through the turmoil, it is hard to avoid discussion of the ways in which this week is similar to or differs from September 2008.
Those who transacted in – or, in Euromoney’s case, reported on – that crisis and the earlier operational disruption and mental anguish of September 2001 are tempted to see in the current situation an awful hybrid of the two events.
Day-to-day price action is reminiscent of the 2008 crisis, but the underlying fundamentals are very different now, UBS analysts note this week in their quarterly macro update. The depth of any resulting recession, they argue, was a function of a build-up of leverage. There is much less of that among households now, and banks are far better capitalized.
The reliance now on disaster recovery and business continuity measures, however, is more reminiscent of the aftermath of the 2001 terrorist attacks in New York, as is the sense that the general public is directly caught up in a horrific and indiscriminate event.
“The impact of the 2008 financial crisis was profound, but the fact is that it was a second-order issue for most people,” says one investment banker who was in a senior role at that time. “Right now, all of this stuff is having an extraordinary impact on everyone.”
Some observers, however, see a continuum between the last crisis and this, despite their utterly different origins.
“The first thing you note is that we are now seeing the unintended consequences of some of the changes that have happened since 2008,” says one veteran market participant.
Asset price moves of the scale seen in recent days are exacerbated by the lack of liquidity that has been caused by the retrenchment of liquidity providers over the years and a thinning out of corporate bond inventory, he argues. “In functioning markets you don’t see it, but in hairy markets you do.”
And like them or not, hedge funds were a substantial provider of liquidity to markets, but that sector no longer operates in the way that it used to, the banker adds. “You are seeing the exaggerated impact of things like programme trading and exchange traded funds (ETFs). The marginal buyer can have a much bigger effect now.”
The loss of liquidity in fixed income, particularly in corporate debt, means that bearish sentiment is finding its expression in the liquid markets of equities and credit ETFs. Corporate bond ETFs are now trading at big discounts to their net asset value: Vanguard’s $55bn total bond market ETF was at 6.2% on March 12.
But others play down the liquidity theme.
“I don’t really buy that, to be honest,” says one banker. “At the margin, maybe lower liquidity adds to volatility, but it’s not the fundamental reason for it and it’s not the reason why companies are running out of money.
“Nobody forced companies and banks to spend the last 10 years buying back shares.”
Another banker argues that bigger balance sheets devoted to secondary trading would not have made much difference now: “The market is moving on lower volume, it’s true, but I don’t think spreads would have been much tighter than they are now.”
The wall-to-wall coverage may be of the virus pandemic, but there is also an oil-price war going on. It already threatens trouble for developing economies that will also surely feel the full force of the health crisis. Oil futures are at 20-year lows as Russia and Saudi Arabia both plan to step up production after failing to agree an extension to current arrangements.
“This is a true credit event laid on top of a stress situation,” says one banker. “I truly think that without the oil-price situation, the market would be functioning a lot better today.”
Not everyone shares that view.
“It’s not helping, that’s for sure, and God knows what they were thinking to do this now,” says one banker. “But if there is one time in history where the oil price is a sideshow, this is it.”
Monetary policy is approaching – or has already reached – the point at which it can do little more, say bankers. After two emergency rate cuts in two weeks, totalling 150 basis points, the US Federal Funds Rate now stands at a range of zero to 0.25%.
The US political administration has come under fire for a sluggish response to the Covid-19 crisis on the social and medical side, but its monetary and regulatory authorities would have been hoping that their Sunday March 15 actions would have had more of an effect on markets this week.
In an echo of the way in which the US government pushed even mighty firms like JPMorgan to make use of support measures in 2008 – the logic being that the stronger banks would serve as cover for the weaker – a coordinated Sunday statement from the Federal Reserve, the Federal Deposit and Insurance Corporation (FDIC) and the Office of Comptroller of the Currency encouraged the biggest banks to access the Fed’s discount window for funding.
To help that, the cost of doing so was slashed by 150bp. A statement from the Financial Services Forum duly followed, confirming that all eight US global systemically important banks (G-Sibs) were drawing from the facility.
“While forum member institutions individually have substantial liquidity and multiple sources of funding, they believe it is important to lead by demonstrating the value of the Federal Reserve’s discount window facility and to encourage its use by other financial institutions,” said the forum.
It was a stark message, coming as it did after a frantic 24 hours in which the central bank had encouraged banks to draw down on their capital buffers, followed by banks themselves suspending share buybacks.
“If the pre-Covid-19 plan had been to allow bellwether names like JPMorgan to dip into the funding pool as a gradual means of shifting perception, this amounts to a cannonball,” wrote analysts at CreditSights.
Sure enough, the big eight were soon followed by regional banks, with US Bancorp, PNC, Fifth Third and Regions estimated to be in line to save some $3.1 billion in previously authorised share buybacks, according to CreditSights.
For the eight G-Sibs, the figure is $33 billion, with $9 billion each coming from Bank of America and JPMorgan.
Before that, the Fed had last week announced a new quantitative easing programme of $700 billion, aimed at US Treasuries and mortgage-backed securities.
Analysts at Bank of America saw the combined Fed moves as long-term.
“The Fed is not just cutting in the face of this shock, with a quick reversal thereafter,” wrote Michelle Meyer, the bank’s head of US economics.
Mark Cabana, head of US interest rate strategy at BofA, noted that this was “just the start of what is needed to calm markets”, but that even coordinated and forceful action from all branches of government might not be able to stop markets from weakening amid widespread quarantine measures.
The capital buffer move frees up a lot of capital, even at the lowest estimates.
Using the G-Sib buffer would make some $380 billion available at the eight biggest banks. Slash all the way to a minimum common equity tier-1 ratio of 4.5% and that extra rises to almost $600 billion.
CreditSights analysts noted dryly that this was the level assumed in the severely adverse scenario of the US annual bank stress tests.
“Fair to say we are in the severely adverse now,” they wrote on Monday.
The ECB, meanwhile, has disappointed some by not cutting its deposit rate from the current -0.5%. There had been hopes of a 10bp reduction even though on the other side of the Atlantic Fed chairman Jerome Powell has ruled out negative rates.
But a €120 billion increase in the ECB’s asset purchase program to the end of the year was welcomed by analysts, as was the plan for the Bank to lend to banks at below the deposit rate if they commit to make enough credit available to borrowers.
That change has been made to the third iteration of the ECB’s targeted long-term refinancing operations (TLTRO III), which will cover the 12 months from June 2020. In the meantime there are tweaks to the existing regime. The criteria for such operations have also been eased: banks will be able to borrow up to 50% of their eligible loan stock, for instance, up from 30%.
European countries have, belatedly, launched stimulus measures to prop up ailing businesses, mostly through loan guarantees. Germany is reimbursing social security contributions as well as backstopping some €460 billion of loans. Bankruptcy deadlines have been eased.
The UK is guaranteeing £330 billion of loans alongside a lending programme from the Bank of England that will offer loans of up to £5 million that will be free of interest for five months. Mortgage borrowers diagnosed with Covid-19 will get three-month mortgage holidays.
France’s loan guarantee is €300 billion, while small businesses also see rent and utilities charges suspended. Banks may ease loan terms. There is talk of nationalizations. Spain has a €117 billion package aimed at easing corporate liquidity worries. Denmark is paying most of the salaries of workers that would otherwise be fired. And so it goes on.
“They’ve broadly done what they can,” says one senior banker of the central bank and government actions. “But the question is delivering on some of all this. It’s one thing to take these measures, but the other is that if people run into financial trouble – which they will – how quickly can you deliver on the guarantees and the loans?
“That kind of thing can get quite granular quite quickly.”
UBS Asset Management has just published its latest quarterly macro report, noting in the current crisis the perfect storm of an oil-price war, the Covid-19 shock and illiquidity in credit markets.
Unsurprisingly, its analysts recommend relative value plays rather than large directional bets, and while they highlight overall economic imbalances that are much healthier than in the run-up to the 2008 crisis, they also produce what must already be a candidate for the biggest understatement of this crisis.
“The longer this goes on,” they declare, “the greater the potential for a non-linear deterioration for households and businesses”.
A non-linear deterioration might be analyst-speak for: ‘Run for the hills’, but while volatility has been spiking and the VIX setting records, credit is far from looking as parlous as it did during the tech collapse of 2001 or the financial crisis in 2008.
High- quality corporates will be bolstered by the moves on both sides of the Atlantic to support the commercial paper market. That matters very much for big, strong triple-B rated names, not least because if they cannot finance themselves in the CP market, they must resort to drawdowns of bank loans. And as Boeing showed, that route is one of the surest ways to sow fear of a corporate crisis developing into something more toxic to the financial sector.
Lower rated names do not as a rule have access to CP, but while double-B to triple-B spreads in the US have risen above 300bp, compared to the high 50s in December 2019, in December 2008 that spread was over 650bp. Likewise, spreads from high-grade to high-yield are approaching 600bp from about 300bp not very long ago. But in December 2008 the gap was over 1,500bp.
Any easing of the pressure on bank credit lines is useful even if there is little concern that banks can meet demand from big corporates without buckling. US bank regulation already bakes in substantial draw-downs of committed facilities when it comes to assessing the sector’s ability to withstand stress.
What regulators and politicians worry about more is the small and medium-sized enterprise sector, and this is where the CP intervention trickle-down effect can help.
“By freeing up CP for the big firms, you limit the strain on the financial sector,” says one capital markets banker. “You will still see corporates being cautious and paying up to draw down their lines, but regulators really want the banks to keep their firepower for where it is needed more, which is to help SMEs.”
Version or reversion?
It is still early to assess with much clarity what, if anything, will persist of the changes that coronavirus has forced upon the world of business and policy. Will it be a reversion to normal or a version of normal?
One area where many seem to agree is that from an operational standpoint, banking will not be quite the same. This is not because of some virus-imposed epiphany for senior management but more because many of the measures being taken are in line with the cost-cutting and efficiency orthodoxy of recent years.
“There will be much less travel for sure,” says one European banker. “Clients will accept that a lot more, and in the end it will be good for the environment, which fits with the industry’s ESG ambitions.”
The nature and expectation of government support will be a question that lingers longer than it did post-2008, bankers think.
“I think one fundamental question that comes from this crisis is: where does government support begin and end?” says one market participant. “If you sit in an oil and gas company or an airline and you have watched the banks being bailed out before, that’s what you are going to be saying.”
US president Donald Trump’s move this week to effectively backstop the airlines, proposing a $50 billion stimulus package, is certainly a response to that feeling.
Appropriately in the year of Brexit, the current crisis is also expected to revive yet again talk of the sustainability of the European Union project in its current form.
“I do think this will give cause to some real issues around how the EU operates and its ability to withstand shocks,” says the same banker.
But both sides of the debate will be strengthened – those arguing for greater integration as a way of bolstering the bloc’s defences and ability to respond to a health emergency, and those arguing for the formal acceptance of a multi-speed union that would see a core group of countries less rigidly tied to the weaker periphery, a structure suggested by French president Emmanuel Macron in 2017.
“It’s not clear to me that the eurozone recovers from this,” says another banker. “The northern Europeans can afford this, but in southern Europe that is not the case. Italy has handled the situation badly and cannot afford the damage without its German backstop.”
And for all the aspirational talk of the world emerging from the Covid-19 crisis with a renewed awareness of the value of global cooperation, everything appears to point to the opposite. The era of presidents Trump and Xi has pitched the US and China against each other in most areas, and a spat about the origins of the coronavirus outbreak is just the latest of these.
“The US and China are clearly going at it, but I think there is a broader question of how the relationship between the US and its allies is impacted,” adds the banker. “That seems to me to be a pretty significant issue.”
On corporate operations, no one is expecting supply chains to be unwound radically: just-in-time has created production and distribution efficiencies that would have been unimaginable without it.
There may however be more focus on proximity – or at least reducing the inefficiencies and risks involved with parts crossing and recrossing borders as a product is assembled.
For banks, although they are being freed from strict application of certain capital requirements now, few expect that to outlive the crisis. Something that might persist, however, is the long-running clamour for a softer approach to CECL, the current expected credit losses accounting standard that was brought in at the start of the year.
Central to CECL is an assessment of the outlook for the credit environment when judging likely losses over the life of a loan. That assessment is getting worse by the day. The least that might be expected is an extension of the three-year phase-in period.
The other side
It is still the early days of this crisis in its truly global form, but much of the ammunition must now have been exhausted. Much will now depend on the science – and on governments’ ability to keep populaces contained while healthcare systems and research catch up.
But bankers are certainly able to look through the immediate carnage, assuming that the science will pull through. Speaking to the senior debt banker, Euromoney is tempted to conclude that the market gyrations trashing the buy side are an indication of where a longer-lasting crisis might one day emerge. Is that right?
“I think we will again be looking at the regulations,” he sighs. “The post-2008 buffers have worked for the banks on the liquidity side, but regulators will have to look at the funds.
“How can you have funds allowing daily liquidity to clients when that is totally asymmetrical to the liquidity that the funds can find in the market? It is not mis-selling, but you are giving something to your client that is not sustainable.”
It has long been said that the next crisis would be forged in asset management. The trigger for the current turmoil was the pandemic, but it will surely have fired a warning shot for the funds industry. This banker certainly thinks so.
“The reality is that in 2008 we dealt with only one part of the problem,” he says.
For the moment, though, those pricing deals and advising clients are surveying a blasted landscape while trying to manage their personal situations. Some are fatalistic: this crisis was triggered by coronavirus, but it could have been anything.
“There has been an asset-price bubble for some time, and markets were looking for some excuse for that to change,” says one.
“They found it.”