We have seen some strange moves in financial markets over the last two weeks. The dollar has slumped, then soared. Governments have basically underwritten corporate credits yet credit spreads have widened out to levels not seen since the GFC. Gold prices tumbled by 10% and are now climbing once again. Government bond prices have swung wildly, gilt prices slumped by over 10% at one stage. What is going on?
Below are 10 observations:
1. Adverts: Watching TV over the weekend, it is almost comical to watch adverts for cruise holidays and to see offers for two frozen pizzas for £5 – as if supermarkets have any left in stock. However, this underlines how rapidly the situation is moving. This crisis has not developed in weeks, but in days. The global financial system is struggling to deal with the speed and magnitude of the changes..
2. Loo rolls: Are we not using the same amount? Admittedly wholesale supplies (offices, restaurants etc) now need to be redirected through the retail system and this is exacerbating the supply situation but people are stockpiling. This metaphor can be carried to other parts of the economy. Distribution routes both of goods and finance are having to adapt, hoarding is taking place.
3. Cash: I normally carry around £100 in cash on me. Over the weekend I withdrew three times that amount. Many people live from one payday to the next. They will now be trying to build up some precautionary savings. Others will be building up their cash deposits. Those who have suddenly lost their job have a real problem. They will be desperate to liquidate assets (if they have any) and will be happy to sell at a discount, despite the fact that asset prices have slumped in response to the economic shock.
4. Business: Businesses have a similar desire for cash as individuals. Governments are helping support companies in trouble, in the hope that they can keep people employed and businesses functioning (the leisure, non-food retail, and hospitality industries are all big employers). Note that the unemployment rate in Norway has gone up from 2% to 5% - this in just one week. Expect similar numbers in the US (where initial claims could jump from a typical weekly loss of 300k to 3 million, in comparison weekly initial claims peaked at 660k in 2008). Businesses are stockpiling cash, just as shoppers are buying loo roll. Fortunately, cash can be created with the click of a button by Central Banks (CBs). However, distributing it to those in need is not simple.
5. International trade flows: The flow of goods across trade routes is matched by payments going the other way. Most international trade is settled in dollars. International trade flows have crashed, so has the movement of dollars across the financial system. Few businesses will have been prepared for such an abrupt halt (see point 1 above). The Federal Reserve has opened swap agreements with other major CBs, however, there still appears to be a huge shortage of dollar cash. The dollar has surged by 8% over the last two weeks. I suspect that this is down the technical demand situation rather than anything else. Emerging Markets are particularly vulnerable, especially those nations reliant on oil sales.
6. The banking system: capital markets have been closed for any companies wishing to raise finance over recent days. CBs are helping very large companies directly through the commercial paper market though most businesses are reliant on banks for finance. Companies are drawing upon pre-existing credit line agreements - all at the same time, which creates an issue for banks.
Banks are highly regulated, and these regulations are impeding getting the cash from CBs to businesses. Bankers remember the fines and castigation that banks endured post 2008, they don’t want a repeat. Volatility in markets is affecting their ‘risk weighted asset’ exposure and these days banks are expected to provision for bad loans almost immediately once the probability of default rises, rather than wait for payments to be missed.
Extending loans increases banks’ balance sheets. Post GFC regulations look to restrict this, forcing banks to raise capital or curtail other activities to redeploy their balance sheets to the areas where it is most needed (CBs have allowed banks to reduce their counter cyclical capital buffers to help offset this). Bank activity in repo markets and corporate bond dealing have been cut back nevertheless and spreads have widened as a consequence. The Fed’s recent decision to open its window to primary dealers & brokers should help. However, it will still take time to cut through the thicket of red tape to get these markets fully functioning again.
7. These strains in the global financial system may explain why we saw such pronounced moves in government bond markets the week before last. The gilt index shed 10% for instance, US Treasury prices also fell though not to the same extent. People are selling what they can to raise liquidity.
8. Credit spreads and liquidity in corporate bond markets have deteriorated markedly. Bid/offer spreads have widened, therefore exacerbating the situation, as are sales from ETF holders. Note around half of all US Investment Grade (IG) is rated just BBB, a credit downgrade will push them into the High Yield (HY) index, where credit spreads & bid/offer spreads are even wider. This is a market that has struggled to find a bottom and is likely to overshoot on the downside. Given the support offered to businesses by governments in Europe (and perhaps soon in the US), markets may well have already overshot and could present a better return/risk profile than equities.
9. The CBs will be alert to these strains in the system. In time these strains will sort themselves out but in the meantime, weaker companies risk collapse. CBs are being very active to prevent this. Returning to point 2: once you believe there is no shortage of loo rolls, there is no need to hoard them. The cash squeeze could suddenly lift.
10. Trading any Fixed Income opportunities out of existing positions (e.g. selling IG and buying HY) needs to be tempered by the wide spreads. New cash buyers will have the most attractive opportunities.
As at 23rd March 2020
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