The liquidity fiction
When the Federal Reserve launched its bond buying programs during the Great Financial Crisis over a decade ago, it told the world that it was merely providing liquidity to markets that had needed it. It was acting as the market maker of last resort, it said, because its role was to ensure the integrity of the financial system.
The key to this fiction was that the Fed, by buying only high grade securities, could claim it was not engaged in credit easing aka qualitative easing, where it was taking risk onto its balance sheet and buying bad assets that bailed out investors. It was only engaged in quantitative easing, which it said lowered risk-free Treasury interest rates and provided liquidity to the mortgage-backed securities market. And so we played along, knowing it was a slippery slope.
But, a precedent had been set. We knew that when rates reached the zero lower bound and the economy was in dire straits, the Fed would pull the bond-buying screwdriver out of its toolkit. The only question was how far the Fed would go to protect itself against the claim that it was just providing liquidity and not propping up asset markets.
We know how far the Fed is willing to go now — all the way down to high yield credits. Junk bonds. The Fed is buying junk. They announced the decision yesterday. And they can spin it however they want. The reality is that, in buying non-investment grade securities, they are propping up asset markets and putting money directly into the pockets of asset managers and dealers. And now, having crossed this Rubicon, we have to ask when the Fed starts buying equities, because now we know they see their tool kit as limitless.
The Fed announcement
The Fed is using its unlimited checkbook to create money and buy things. Below is the language it used to describe its aim. I have highlighted the important bits.
- “Bolster the effectiveness of the Small Business Administration’s Paycheck Protection Program (PPP) by supplying liquidity to participating financial institutions through term financing backed by PPP loans to small businesses. The PPP provides loans to small businesses so that they can keep their workers on the payroll. The Paycheck Protection Program Liquidity Facility (PPPLF) will extend credit to eligible financial institutions that originate PPP loans, taking the loans as collateral at face value”
- “Ensure credit flows to small and mid-sized businesses with the purchase of up to $600 billion in loans through the Main Street Lending Program.”
- “Increase the flow of credit to households and businesses through capital markets, by expanding the size and scope of the Primary and Secondary Market Corporate Credit Facilities”
- “Help state and local governments manage cash flow stresses caused by the coronavirus pandemic by establishing a Municipal Liquidity Facility that will offer up to $500 billion in lending to states and municipalities.”
The first bullet is about making sure workers get paychecks. The second is about supporting small businesses. The junk bond bit is the third section where the Fed aims to “Increase the flow of credit to households and businesses through capital markets.” In the fourth bullet, the Fed has committed to buying municipal bonds.
It’s hard to get a sense for the scale of the asset purchases the Fed is making from the statement because they are engaged in so many markets. For example, the Fed is buying student loans, credit card loans and U.S. government backed-loans to small businesses.
In terms of high yield credit, it is committed to buying individual securities of ‘fallen angels’, that have lost investment grade rating and still trade at BB-, three notches into junk territory. It will also buy junk bond exchange-traded funds like JNK and HYG.
These junk ETFs are not the creme de la creme of high yield. They are a wide cross-section of companies, including lower rated ones. For example, the SPDR Barclays Capital High Yield Bond ETF, ticker symbol JNK, has around 40% of its holdings in BB-rated paper, with a further 45% rated B. I am assuming the other 15% is even lower i.e. CCC.
Regarding the third and fourth bullets, the bond-buying sections, I had predicted the muni bond bit but not the junk bond bit because I didn’t think the Fed would want to remove the liquidity fig leaf. The language is anodyne by design but the reality is in stark contrast. The Fed isn’t just ‘increasing the flow of credit’, it is propping up asset markets plain and simple.
This is simply breathtaking.
Outcomes
Prices on U.S. high-yield bond ETFs soared yesterday after the Federal Reserve announced it would buy junk. JNK and HYG were up nearly 7% on the news. It was the biggest rally in high yield in two decades.
Let’s remember that spreads had reached 1,100 basis points on 23 March, the widest level since the Great Financial Crisis. That’s when Fitch downgraded Ford to BBB-, its lowest invest grade. By 25 March, S&P downgraded Ford to junk, BB+. Macy’s was even removed from the S&P500 on 1 April as Fitch downgraded it to junk.
So, the Fed made a specific provision for these companies, announcing that it would buy bonds of companies that were investment-grade as of March 22 but later downgraded to a rating of no lower than BB-, the third-highest junk grade. This is an idea I mooted regarding how far the Fed would go. And voila, Macy’s and Ford get a bailout. Ford’s stock jumped 11.3% while Macy’s shares rallied 11.5%.
I didn’t expect the high yield ETF purchases though. Opinions on this have been divided. I was firmly in the camp that said the Fed not only wasn’t going to do it – it shouldn’t do it. Full stop. But, now its buying junk ETFs and individual fallen angel bonds. That tells you the Fed is directly propping up asset prices — and of specific companies to boot.
My take
Even so, it can’t entirely eliminate pain in the real economy. Just yesterday, we learned that 16 million people have filed for unemployment claims in the last three weeks. And not everyone is eligible. So many other unemployed people probably did not apply. So, judging from these figures alone, the unemployment rate in the US is already 15% or higher as I write this.
There will be defaults in the junk space, simply because a mass unemployment like this robs people of income to buy things. And even people who can buy things are going to withhold their spending because of the lockdown and fears for the future. And I haven’t even talked about the energy space, which has been decimated.
The Fed has shown its hand here though. And it’s clear that there’s nothing they can’t or won’t buy if this downturn becomes more severe. That includes equities.
Will the Fed’s direct support for asset prices push equities back to new highs though? Maybe. I wasn’t in the camp yesterday. I spoke to my Real Vision colleague Roger Hirst about it on camera yesterday. And the line I took then was that the Fed’s move was more about fallen angels than a wholesale support for high yield. I also showed great scepticism for the Fed’s ability to engineer a full rebound in shares amid the worst economy in 90 years.
But having thought about this overnight, I am not so sure. Roger’s argument was that the unlimited firepower of the Fed was an awesome weapon. And, if they jam it on enough, they well could lift shares to new all-time highs – not just put a floor under shares, but recreate the magic of the bull market.
Is the mantra, then, the same as it ever was – ‘don’t fight the Fed’? For me, today, it seems like, yes, it may well be. There’s nothing the Fed won’t do to prop up asset prices. and with its unlimited firepower, it’s hard to bet against them.