Never fight the Fed as they say and yesterday we saw a subtle tweak in their Credit Buying programme that has essentially made the Fed the buyer of last resort of the entire US corporate Bond market. This proved to be a much bigger incentive to the asset allocators buying the dip than the doom and gloom being spread to try and shake out the day traders. Accordingly, HYG, the High Yield Bond ETF that serves as a useful investable proxy for the Junk Bond market stabilised and rallied and the equity markets, which have been moving in lockstep, followed them higher.
Chart1 . Equities and Junk have been following the Fed
Chart 1 highlights how much the recovery from the oversold lows of March has been about risk premia rather than fundamental earnings. US High Yield Bonds have moved up with, arguably led, the S&P500 from the lows as the US Federal Reserve stepped in to address the now too familiar potential crisis of liquidity mismatch.
To recap, traditionally the essential cause of most banking crises is duration mis-match, basically borrowing short term (taking cash deposits) and lending long term. Fractional Reserve Banking means that the long term lending is multiples of the short term cash deposits held (the rest being ‘created’ by the banking system), so if there is a run on the deposits, then there is a need to shrink the other side of the balance sheet, the loans. If these are long term then there is a liquidity mismatch and the Central Bank has to step in as a lender of last resort. However, thanks to our new and sophisticated financial markets, we rarely need the Central Banks to act as lender of last resort. If that’s the good news, the bad news is that those same sophisticated markets haven’t eliminated the risk, they have just moved it elsewhere. Instead, the Central Banks now have to act as buyer of last resort of the financial instruments that have ‘replaced’ traditional bank loans.
In our new ‘alternate’ or shadow banking system, the mismatch is now mainly one of liquidity; financial market instruments such as Money Market Funds or ETFs are still in the business of offering their clients daily liquidity while investing in longer duration assets. And just as before, all is fine until investors want their liquidity back. In 2008, this was a major but largely overlooked driver to market disruption in the wake of the Lehman crash and a classic example of what we refer to as Market Mechanics. As such it is worth reviewing the episode, not least because this is actually what caused a relatively common financial market issue to become an economic one.
History (should) tell us that the 2008 Financial Crisis became an economic crisis because of Liquidity
By early 2008 the traditional US Banking system had been largely replaced by a shadow banking system based in the financial markets. Investors no longer put money on deposit, they put it with Money Market Funds, which grew from just over $2trn in 2006, to over $3.5tn by the Autumn of 2008. On September 16th, a week after Lehman Brothers failed, a $60bn+ Money Market Fund called Reserve Primary was forced along with others to mark down the value of all bonds related to Lehman to zero (including commercial paper) and as a result declared that they had ‘broken the buck’ in other words a $ deposited with them was now worth 97 cents. Understandably this led to a rush for the exit with investors piling into US treasuries to preserve the value of their capital. While the noise traders fixated on the Bond yields and the currency, in the real world, the immediate and highly damaging consequence of this was that the Money Market Funds were now paralysed and unable to fulfil their primary role, which was to provide short term liquidity to corporate borrowers via purchasing 30 day commercial paper. With redemptions soaring they simply could not afford to take the liquidity risk of locking money up for 30 days. The net result of this was the equivalent of the entire US and ultimately western economy having its over-draft pulled. Markets boom and bust all the time and the economy was rarely affected. This time, thanks to the short term collapse in the banking system, the market crisis became a real world one.
We knew this had happened because on October 7th 2008 the Fed suddenly stepped in to buy Commercial Paper, fulfilling their role as lender/buyer of last resort. This stopped the damage getting worse and ultimately righted the system, but the shock was palpable. Without access to short term financing, companies were forced to cut new orders and dump existing inventory, cutting prices in order to generate near term cash flow. Larger companies extended longer credit terms to suppliers in return for better pricing (something we picked up at the time talking to corporates). In fact everything that we saw in the so-called ‘Great Recession’ on 2008/9 can be explained away through the lens of a short term liquidity crisis leading to a massive run down of inventory to keep the metaphorical lights on. Prices dropped sharply to clear inventory, new orders stopped so industrial production collapsed, companies up and down the supply chain ran into cashflow problems and GDP, the measurement of which can be hugely skewed by changes in inventory, unsurprisingly went negative. Of course, once the Fed had provided liquidity the problem stopped getting worse and as soon as that inventory cleared the whole process flipped into reverse and by q2 2009 the so called Great Recession was over. Most economists however, fixated as they were on their housing market thesis refused to acknowledge this and thus missed a decade long bull market.
The Fed has, once again, had to step in to preserve the US Credit System
The reason for the history lesson is not only to point out that the “I predicted a housing market collapse therefore I predicted the Great Recession’ school of economists were largely wrong, but also because the Fed are once again telling us where they see the biggest risks. And it is with US Corporate Bonds. The first action they took in March was to buy in the Bond ETFs, which were making the same old mistake of offering daily liquidity while actually being invested in something which, while liquid, was certainly not always going to be able to be liquidated within a day. This effectively highlighted how the ETF factories like Blackrock were now “Too Big To Fail” and how like the Banks of old and the Money Market Funds of 2008, the Fed was going to step in as lenders buyer of last resort. Yesterday’s move took it a step further, by buying back the underlying corporate credits themselves the Fed is effectively allowing all corporates to borrow at almost zero cost.
There are many ramifications of this, but to pick one of the largest; it basically means that the Fed have now just effectively removed all credit risk from the US Credit Markets. Junk Bonds, no longer exists as there is now no difference in the prospects for a CCC default or a BBB one. From an investor point of view there isn’t one as the Fed are there. At a stroke this takes away the threat of a downgrade ‘cliff’ (the risk that a downgrade in Investment Grade Bonds to junk would overwhelm the much smaller junk bond market). Perhaps we are missing something, but if the Fed has just removed default risk for US corporates, then what is the point of a Credit Rating? Indeed, why do we now need Credit Ratings Agencies?
