NO. 4 ∙ APRIL 2020
Whatever it takes 2.0
AUTHOR: Martin Dreier
Senior Portfolio Manager
The crisis triggered by the coronavirus is escalating day by day. In the war against the exponential spread of the virus, and to prevent national healthcare systems from becoming overwhelmed, there have been profound changes in life outside the home.
Most countries in the world have imposed restrictions on movement, as well as other measures ranging from limiting gatherings of people, through a total shutdown of all non-essential businesses up to the closure of borders. Many people are also self-isolating as a precaution.
In addition to the restrictions on life outside the home, the fight against the pandemic is having a profound effect on the real economy. Not only are factory closures leading to lost production but the livelihood of much of the services industry – direct contact with the customer – has gone. People’s uncertainty about how much the crisis will threaten their job security is further curtailing what consumer spending there is.
The number of new unemployment claims reported in the last week of March in the U.S. gives a first impression of the impact of the crisis on what until then had been a very solid U.S. labour market. Almost 3.8 million claims were filed. This is a sharp spike compared to the average of 311,000 new claims per week over the past 10 years.
The sudden collapse in demand has repercussions for all stages of the value chains. According to a survey conducted by the Association of German Chambers of Industry and Commerce (DIHK) published on 27 March, one in five of the firms polled felt itself at acute risk of insolvency. In times of quarantine or self-isolation no revenue is coming in while current expenses, such as wages and rents, are sucking liquidity out of companies. Until they get clarity on the duration and scale of the coronavirus crisis, companies are trying to conserve liquidity as much as possible. They are placing no more orders and are also giving themselves short- to medium-term financial leeway by drawing down their revolving lines of credit. The resulting outflow of funds is causing serious refinancing problems for banks. While large firms have the option to draw on their lines of credit, small enterprises already cannot pay interest and coupons. In addition, tremendous efforts are being made on the markets to sell assets in order to create liquidity. But selling in the absence of buyers results in prices that may even be below their fundamentally justified prices. Panic breaks out and the crisis begins to fuel itself.
In recent decades, intervention by central banks has been a proven method of putting out the fires. As the ultimate source of liquidity, they have a central role in curbing systemic crises. What’s important is that early signs of support and resolute intervention occur at the right time – this is something past crises have taught us.
The emergency programmes introduced by the ECB and the Federal Reserve in the last few days of March have the potential to take the immediate stress out of the system. The Federal Reserve’s alphabet soup of measures, for example, is aimed at highly diverse sectors of the financial system in order to satisfy the various demands for liquidity. On 23 March, the Fed announced the following programmes to support bank liquidity and lending to private households and companies:
- It will purchase U.S. Treasuries and agency Mortgage Backed Securities in the market in unlimited amounts to provide liquidity in the sovereign bond market.
- The Money Market Mutual Funding Liquidity Facility (MMMFLF) enables banks to buy assets from money market funds that need to meet redemptions.
- The Commercial Paper Funding Facility (CPFF) enables U.S. corporations to refinance short-term debt instruments, and will directly provide the corporate sector with liquidity.
- The Primary Dealer Credit Facility (PDCF) enables banks who are allowed to trade directly with the Fed to pledge business loans, commercial paper, municipal bonds and even equities as collateral for credit. It is designed to allow lending to households and to the corporate sector to become fully functional again.
- The Primary Market Corporate Credit Facility (PMCCF) is intended for the purchase of new investment-grade U.S. corporate issuances with a residual maturity of up to four years. The Federal Reserve’s intention is to secure funding for large companies.
- The Secondary Market Corporate Credit Facility (SMCCF) enables banks to sell outstanding bonds. It gives brokers an opportunity to offload credit risks that cannot be sold in the market. This relieves the bank books and will in turn mean that brokers start to trade in credit risk again. For unsaleable assets, there is an out.
- The Federal Reserve has restarted the Term Asset Backed Security Loan Facility (TALF), which people will be familiar with from the financial crisis, to facilitate loans to consumers. Securitised auto loans, student loans, credit card receivables and the like can be pledged by banks as collateral for new loans.
These programmes amount to up to USD 4 trillion in addition to the unlimited purchase programmes for U.S. Treasuries and U.S. agency debt.
In the eurozone the ECB decided back on 18 March to launch a new, time-limited purchase programme. The Pandemic Emergency Purchase Programme (PEPP) will enable the ECB to buy up to EUR 750 billion in sovereign bonds, asset-backed securities, covered bonds, and corporate bonds with an investment-grade rating. At the same time, the ECB announced that under PEPP it would be able to deviate from the central bank capital key, paving the way for bonds from peripheral countries whose debt levels are already high, like Italy, to be purchased to a greater degree. In addition, it is making an exception for Greek sovereign bonds, since Greece’s high yield rating does not meet the standards for asset purchases. The ECB’s intention is also to provide liquidity to the markets, reduce refinancing costs and avert a systemic crisis in financial markets.
The scale of the monetary packages just announced by the central banks in the U.S. and Europe exceeds all historic stimulus packages introduced in the 2008 global financial crisis and in the 2011/12 euro crisis.
However, liquidity measures are not enough to solve the problems in the real economy. This requires coordinated fiscal programmes that specifically assist employers and employees affected by what is – it is hoped – just a temporary shutdown. This strikes us as much easier to implement in the U.S. than in a fragmented European Union where the national governments pursue their own interests.
No programme, be it fiscal or monetary, can fund a long-lasting suspension of people’s public lives and economic life. So, first and foremost, it is absolutely essential to get the spread of coronavirus under control, primarily to limit the human toll but also to give planning certainty back to employers and employees. The measures of central banks and the emergency lifelines in Europe and the U.S. are the first important steps in cushioning the blow of the coronavirus crisis, and at the same time a positive signal to the economy and capital markets. However, they certainly won’t be the last.