We Can Fix the Liquidity Crunch, But Can't Avoid the Economy Crunch

It feels like weeks ago that the Fed cut interest rates to zero, but it was only Sunday! What has happened since, both in terms of markets and in terms of additional policy measures will be instructive for helping us navigate during this period of extreme volatility. There are two separate problems facing policy makers We are dealing with an unprecedented collapse in real economic activity due to social distancing across the U.S. There is very little policy makers can do to prevent that from happening. As we are all self-isolating, we are definitely going to be spending less money. On the real economy side, we need fiscal measures to help people who are either laid off or lose hours continue to pay their bills. We also probably need some kind of aid to businesses impacted to avoid a mass of bankruptcies among restaurants, hotels, resorts, independent retailers, etc. It sounds like Congress and the President are coming around to the need for aggressive measures on this front. Totally separately, we are seeing a major liquidity crisis grip financial markets. Obviously the two are related in the sense that real financial pressures have emerged because of the coronavirus. However, the solutions to the liquidity crunch really have nothing to do with what is happening in the real economy. We can definitely fix the liquidity crunch, even if we can't avoid the real economy crunch coming. How do we know it is a liquidity crunch and not just a reaction to a steep recession? In 2008, the primary problem was that banks were facing huge losses from home loans and related securities. These losses blew huge holes in the banks' capital, and they had to sell assets and/or stop lending in order to repair those capital holes. Hence the solution was fairly easy: Have the government inject fresh equity capital into the banks, then proscribe exactly how much private capital they had to raise from there. In this case, it isn't that simple. While banks may ultimately face some serious delinquencies, it certainly hasn't happened yet. Banks as a group came into this period with excellent credit loss metrics. However for whatever reason, likely a number of reasons, Wall Street banks find themselves very constrained, and appear to be trying to pull back from lending activity even further. So, while the underlying cause is different than the Financial Crisis, the result is the same. Wall Street is not performing their normal market functions. Hence the market behavior is reminiscent of the darkest days of 2008. We can see this by looking at securities that are obviously money good but are trading erratically, such as government-guaranteed mortgages or AAA-rated municipals. We can see it by looking at trades that are popular with hedge funds, such as futures based trades or CLOs. We can see it in the bid/ask spread on Treasury bonds. We can even see it on days like Wednesday, where the 30-year Treasury was down in price at the moment when stocks hit the circuit breaker. We see it with municipal money market securities, which traded at 5% or more on Wednesday. We see it in mortgage REITs liquidating, which was happening on Wednesday as well. I could go on. Markets like stocks and corporate credit should absolutely be lower in price purely on the real economy. But action in a lot of these other securities only make sense if there is a liquidity squeeze going on. Why haven't the Fed's actions to date alleviated the liquidity problem? My best guess is that there are many reasons why liquidity has been drying up. Again, unlike in 2008 when the root cause was obvious and the whole debate was around how to deal with that root cause, today the causes are probably varied. We know that many companies have drawn all of their credit lines all at once, taxing bank balance sheets. We know that in volatile times banks pull back the amount they will lend to investors, like hedge funds or mortgage REITs. If those players were at max leverage or if losses in their portfolios cause them to get margin calls, that makes them forced sellers. It seems likely that some non-U.S. entities are in need of dollars, but cannot access them through the normal channels, such as using repo against a Treasury bond portfolio. It looks to me like Treasury bonds are being dumped indiscriminately in order to get access to cash. Muni bond funds and Bond ETFs have seen large outflows, probably due to benign reasons like investors looking to rotate into stocks. But the flood of selling is hitting a skittish market, causing major dislocations. The apparent liquidity of the ETF in this case is deceiving. The velocity of money has collapsed due to the sudden decline in transactions. This has the effect of draining the banking system of deposits. Lastly, banks are probably anticipating some amount of normal losses stemming from the real economy. Perhaps these haven't happened yet but they are coming. The Fed has tried to attack this problem from two directions. First they have tried to give banks an incentive to expand their balance sheets. They have made funding cheaper by cutting the fed funds rate and made it more available by increasing their repo offerings. On Wednesday they also reopened their Primary Dealer Credit Facility, which offers 90-day financing of a whole host of fixed-income assets, from Treasury bonds to munis to AAA-rated CLOs. The other direction is by buying up assets directly. On this front, they've only begun. Right now they are buying Treasury bonds and MBS through QE, and buying commercial paper through the Commercial Paper Funding Facility, which they restarted on Tuesday. Not only have these actions not worked, conditions have only gotten worse. And since the worse things get, the more margin calls, and subsequently the more forced sales that happen, it feeds on itself. What comes next? Wednesday the Financial Times published an Op-Ed penned by former Fed Chairs Janet Yellen and Ben Bernanke. They advocated for two new things the Fed hasn't done yet: expand the QE buying to other assets and launch a funds for lending program. I believe both will happen, with the former probably coming in the next few days, while the latter may take a bit longer. Both of these programs exist with other major central banks, include the ECB, Bank of England and Bank of Japan, which will give the Fed comfort. I believe they will soon add municipals and corporate bonds to their QE program. This would go a long way to alleviating the overhang on dealer balance sheets. They will probably also increase their Treasury purchases. The fiscal solution to Covid-19 will result in larger deficits. Primary dealers need balance sheet to run those Treasury auctions. If the Fed takes on more of the Treasury market itself, that will alleviate that capital need. The Fed is undoubtedly frustrated by the fact that Treasury rates have actually risen since they cut rates to zero at the start of this week. Heck, the 10-year Treasury is higher in yield than the day before they did their emergency cut on March 3. That means that in fact, monetary thrust is getting tighter, not looser. The Fed will need to take control of the yield curve, and they will do so by imposing caps on shorter-term yields. I think they'll start by targeting the 2-year at something like 25 basis points and the 5-year at 50 basis points. I also expect this to come any day now. Don't fight the Fed With the parts of the market where the Fed has a real ability to directly influence, they will get their way. It may take some time to find the right set of tools, but it will happen. I have a hard time knowing when is the right time to buy more cyclically exposed assets. As in, how do you know when to buy stocks when you have no idea what earnings will look like? But if indeed the Fed chooses to buy munis or higher quality corporates, those sectors will come unlocked. If they cap yields and flood the market with QE until those bonds drop to those yields, it will work. Those are the places I'm looking to place capital.

We Can Fix the Liquidity Crunch, But Can't Avoid the Economy Crunch

Action in a lot of these other securities only makes sense if there is a liquidity squeeze going on.

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