The Solvency Problem

Doug Nolan

Being an analyst of Credit and Bubbles over the past few decades has come with its share of challenges. Greater challenges await. I expect to dedicate the rest of my life to defending Capitalism. One of the great tragedies from the failure of this multi-decade monetary experiment will be the loss of faith in free market Capitalism – along with our institutions more generally.

Somehow, we must convince younger generations that the culprit was unsound finance. And it’s absolutely fixable. Deeply flawed, experimental central banking was fundamental to dysfunctional markets and resulting deep financial and economic structural impairment. The Scourge of Inflationism. If we just start learning from mistakes, we can get this ship headed in the right direction.

Over the years, I’ve argued for “rules-based” central banking that would sharply limit the Federal Reserve’s role both in the markets and real economy. The flaw in “discretionary” central banking was identified generations ago: One mistake leads invariably to only bigger blunders.

What commenced with Alan Greenspan’s market-supporting assurances of liquidity and asymmetric rate policy this week took a dreadful turn for the worse: Open-end QE, PMCCF, SMCCF, MMLF, CPFF, MSBLP, TALF… They’re going to run short of acronyms.

Our central bank has taken the plunge into buying corporate bond ETFs, with equities ETFs surely not far behind. The Fed’s balance sheet expanded $586 billion – in a single week ($1.1 TN in four weeks!) – to a record $5.25 TN. Talk has the Fed’s new “Main Street Business Lending Program” leveraging $400 billion of (this week’s $2.2 TN) fiscal stimulus into a $4.0 TN lending operation. Having years back unwaveringly set forth, the ride down the slippery slope of inflationism has reached warp speed careening blindly toward a brick wall.

Ben Bernanke, appearing on CNBC, March 25, 2020: “Low interest rates are not - and I know some of you will be skeptical - but it’s just a fact that low interest rates around the world are not primarily a monetary policy phenomenon. Interest-rates around the world have been declining since the eighties. And if you look at the 10-year Treasury yield since 1980 from then till now – 40 years – it looks like a ski slope.

The rate just keeps coming down and down and down. And as I’ve talked about before, I think what we have in the world now is a global savings glut. Longer life spans, rising incomes and for a variety of reasons there’s a lot of savings in the world. Any asset manager will tell you that – and it’s hard to find good uses for that money – hard to find good capital projects.

Even when monetary policy is at a normal level - and we got pretty close to a normal level when the Fed was raising rates earlier - interest-rates are going to be much lower than in the past. So low interest rates are something we’re going to have to live with for a while very likely. And we have to be very alert about financial risk. The Fed is looking at that at much more detail than we used to. But, again, it’s not a monetary policy thing. It’s a long-term trend.”

The Fed “very alert about financial risk”? What exactly has the Fed been “looking at at much more detail”? Financial excess? Speculative leveraging? Mounting vulnerabilities in the derivatives complex, the ETF universe, corporate leverage? Global hedge fund leverage? Highly levered mortgage companies?

We’ve now witnessed two historic bouts of market illiquidity and dislocation – exposing massive speculative leveraging – and Dr. Bernanke sticks resolutely with his “global savings glut” thesis. Central banks have during this cycle created more than $16 TN of new “money,” for heaven’s sake. Of course it’s been “a monetary policy thing.”

I’ve always viewed Bernanke as a decent man. But as a central banker – as the mastermind for the terminal phase of a runaway global monetary experiment – he’s been a disaster. His analytical framework is so flawed it’s difficult to comprehend the amount of power and discretion placed in his hands.

It was Bernanke that invoked the government printing press to resolve whatever might ail the markets or economy. His crackpot theories that the Fed’s failure to print sufficient money supply after the ’29 stock market crash caused the Great Depression should have been sternly rebuked years ago. Worst of all, Dr. Bernanke specifically used the risk markets (stocks, corporate Credit, derivatives and such) as the primary mechanism for post-Bubble system reflation. The former Fed chief is the father of “QE,” “helicopter money,” and the ETF complex that took the world by storm.

Documenting for posterity the ever-lengthening list of lending facilities, this week from the Federal Reserve:

“The Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds.”

“The SMCCF will purchase in the secondary market corporate bonds issued by investment grade U.S. companies and U.S.-listed exchange-traded funds whose investment objective is to provide broad exposure to the market for U.S. investment grade corporate bonds.”

“The Money Market Mutual Fund Liquidity Facility (MMLF) to include a wider range of securities, including municipal variable rate demand notes (VRDNs) and bank certificates of deposit.”

“Facilitating the flow of credit to municipalities by expanding the Commercial Paper Funding Facility (CPFF) to include high-quality, tax-exempt commercial paper as eligible securities.”

“…A Main Street Business Lending Program to support lending to eligible small-and-medium sized businesses, complementing efforts by the SBA.”

“The TALF is a credit facility authorized under section 13(3) of the Federal Reserve Act intended to help meet the credit needs of consumers and small businesses by facilitating the issuance of asset-backed securities (“ABS”) and improving the market conditions for ABS more generally… The TALF SPV initially will make up to $100 billion of loans available.”

The Fed was to expand its assets by at least $625 billion this week. In concert with global central bankers, unprecedented liquidity operations coupled with a massive U.S. fiscal program was sufficient to reverse collapsing global markets. Once reversed, there was more than ample fodder from the reversal of short positions and market hedges to power a historic market spike (“biggest three-day surge since 1931”).

Chairman Jay Powell, appearing Thursday on the Today Show: “There’s nothing fundamentally wrong with our economy. Quite the contrary. The economy performed very well right through February. We’ve got a fifty-year low in unemployment for the last couple years. So, we start in a very strong position. This isn’t that something is wrong with the economy.”

Powell’s optimism was echoed by regional Fed presidents: Dallas’s Robert Kaplan: “We were strong before we went into this, and we believe that we’ve got a great chance to come out of this very strong.” Atlanta Fed President Raphael Bostic: “The economy started at a great place.”

The Fed believes it has “temporarily stepped in to provide loans” - for a system considered fundamentally sound and robust. I am an analyst and not a pessimist. But, most unfortunately, the opposite holds true.

U.S. and global economies were unstable “Bubble Economies” fueled by Credit and financial excess, most notably by unprecedented asset market speculative leverage. Fed assets surpassed $5 TN this week, and I’ll be stunned if they ever again fall below this level.

I am reminded of Fed officials having actually expected in 2011 that its “exit strategy” would return the Federal Reserve balance sheet to near pre-crisis levels – only to double assets again in about three years to $4.5 TN.

The Austrian “Bubble Economy” concept will be invaluable as we analyze dynamics going forward. From the economic perspective, a decade of ultra-loose financial conditions incentivized businesses to overborrow – from multinational corporations, to mid- and small business to sole proprietorships.

Tens of thousands of unprofitable (and negative cashflow generating) enterprises proliferated throughout the economy – from Silicon Valley “tech Bubble 2.0,” to shale, alternative energy, biotech, media, entertainment and leisure, and so on. Ultra-loose financial conditions stoked over- and mal-investment, while generally distorting business spending patterns. Confounding post-Bubble financial and economic landscapes will create investment decision mayhem.

U.S. (and global) economies are severely maladjusted – and ravenous Credit gluttons. Importantly, this ensures Trillions of monetary stimulus along with Trillions of fiscal spending will be absorbed as if dumping buckets of water onto the scorching desert sand.

Stimulus will for a time sustain scores of uneconomic enterprises, at the cost of prolonging the workout process. Nonetheless, with Bubbles popping in shale, technology, leisure and entertainment and elsewhere, millions of job losses will prove permanent.

Negative wealth effects will also wreak havoc on consumer spending patterns. From the Fed’s Z.1 report, Household Net Worth (Assets less Liabilities) ended 2019 at a record $118.4 TN, having ballooned $23 TN, or 21%, over the past three years. Household Net Worth ended 2019 at a record 545% of GDP, up from previous cycle peaks 492% (Q1 2007) and 446% (Q1 2000). Household holdings of Equities (Z1: Equities and Mutual Funds) ended Q4 at $30.8 TN, a record 142% of GDP (up from 2007’s 102% and 2000’s 117%).

Now comes the downside. Easy gains from asset inflation are spent more freely than incomes.

Changing spending patterns will now expose the fragile underbelly of the “services” and consumption-based U.S. economy.

Meanwhile, some of the most expensive real estate markets in the country will suffer collapsing demand, with major effects on construction, spending and confidence (not to mention loan losses).

One of the many lasting pandemic consequences will be a reassessment of living in New York City, San Francisco, Los Angeles and other densely-populated urban centers. Beyond negative asset market wealth effects, I expect a prolonged impact on high-income earners (i.e. Wall Street compensation, executive pay, company stock rewards, Silicon Valley, entertainment and media, real estate-related, etc.).

Expect upper-end real estate Bubbles – having persevered even through the last crisis - to finally succumb. The bursting of an unprecedented nationwide commercial real estate Bubble will have major impacts on construction and the finances of owners of real estate, as well as on the underlying loans, securitizations and derivatives.

Every segment of the economy will be impacted – many deeply. Expectations for a quick recovery are wishful thinking. And I doubt it will be possible for the Fed and global central bankers to step back from market liquidity support operations. We should not be surprised by ongoing weekly Fed balance sheet growth of several hundred billion.

Household, business and market confidence has been shaken – and will be slow to recover.

Markets have been conditioned over recent decades to anticipate rapid recovery. Confidence was bolstered this week by incredible “whatever it takes” measures. I’m just not convinced the necessity for ongoing rapid central bank expansion will prove as confidence inspiring.

New York state reported its first coronavirus on March 1st. In less than four weeks, cases multiplied to 45,000. From the February 22nd CBB: “Cases tripled to nine Friday in Italy, with the first death reported.” Italy reported 919 deaths Friday, with total deaths of 9,134 and cases of 86,498.

Governments have made very unfortunate missteps managing this pandemic. Many now look to the trajectory of China’s outbreak for hope that cases elsewhere will begin declining soon - with economic normalization commencing in earnest.

Yet Western democracies have a major disadvantage in managing a pandemic. Societies would not tolerate health authorities going door to door checking for symptoms and removing those with fevers (sometimes kicking and screaming) for immediate transport to isolation facilities.

One has only to view photos of a bustling Central Park or videos of crowded NYC subways to realize that “lock down” means something quite different in the U.S. than it does in Wuhan and Hubei Province. And only China has 170 million cameras and a sophisticated surveillance system – that in one case provided the ability to track an infected individual “down to the minute” as he traveled between provinces and along public transit in Nanjing.

Bill Gates’ comments (CNN Coronavirus Townhall, March 26th) resonated. Having warned of pandemic risk in a 2015 TED talk, and after years of being fully immersed with the Bill and Melinda Gates Foundation’s efforts in infectious disease control, vaccines and other global health initiatives, Gates possesses deep understanding of the subject matter.

His view is that nationwide shutdowns and social distancing efforts must be strictly maintained until the number of active coronavirus cases declines to a low and manageable level. A cursory glance at one of the nationwide outbreak maps is sufficient to appreciate that the outbreak is currently out of control throughout the country.

We’ll learn more next week, but it appears the White House is moving forward with a plan to gauge the outbreak across the country in a county by county effort to get the economy moving back toward capacity as soon as possible. It’s difficult for me to see governors, mayors, local government officials and vulnerable healthcare systems around the country supporting any relaxation of pandemic management efforts.

Unfortunately, there will be no speedy economic recovery.

Let’s hope the change of season offers some relief. But then there’s the loaming prospect for a second wave next fall and winter. Various experts, including Bill Gates, say a vaccine is a year to 18 months out. There’s going to be a hell of a battle in deciding how best to move the economy forward from here.

As for the markets: markets will do what markets do. And global market dynamics are incredibly unsound. Count me skeptical that the biggest three-day rally (in the DJIA) since 1931 is a sign of health. I fully appreciate that “buy the dip, don’t be one” has been richly rewarding for a long time now.

“There couldn’t be a better time to start investing [than] right now… Fortunes are going to be made out of this time… I can guarantee you that if you stay in and you just stick with it, three years from now you will be very, very happy that you did.” I’d be especially cautious with guarantees. Suze Orman (and most) have little appreciation for what is now unfolding. The younger generation has yet to experience a grueling protracted bear market. “Buy the dip” and “buy and hold” are poised to dishearten.

Incredible central bank liquidity operations yanked global markets back from the precipice. In the three sessions, Tuesday to Thursday, the Dow surged 21.3% (ending the week up 12.8%). The week saw the S&P500 rally 10.3%, lagging the Japanese Nikkei’s 17.1% surge. Brazil’s Bovespa recovered 9.5%, as emerging equities bounced back. Mexico’s peso rallied 4.6%, leading an EM currency recovery. In “developed” currencies, the Norwegian krone rallied 11.6%, in another week of acute market instability.

After spiking 44 bps the previous week, investment-grade Credit default swaps (CDS) this week sank 40 to 112 bps. The iShares investment-grade corporate bond ETF (LQD) surged 14.7%, more than reversing the previous week’s extraordinary 13.3% decline.

The Fed’s move to open-ended QE coupled with corporate bond and bond ETF purchases was instrumental in arresting market collapse and sparking upside dislocation. This, along with expanded global central bank swap arrangements, reversed global market illiquidity and panic.

If I believed global markets were chiefly facing liquidity issues, I would be more hopeful.

Illiquidity was pressing, and global central bankers responded with “whatever it takes” (and it took a lot). But believing the global Bubble has burst, I see the overarching issue more in terms of a developing Solvency Problem.

Burning the midnight oil in homes around the globe, rating agency employees enjoy enviable job security. And that would be Credit analysts for corporations, financial institutions, municipalities, investment-grade bonds, junk debt, structured products and nations. Credit and Solvency issues will turn systemic.

It’s a different world now. And while “whatever it takes” can accommodate speculative deleveraging and generally support market liquidity, The Solvency Problem will prove a historic challenge.

The global economy has commenced a major downturn, hitting an already impaired global financial system. While markets enjoyed a recovery this week, EM debt is turning toxic. Energy-related debt is already toxic. Risk of general business and real estate debt turning toxic is growing rapidly.

As I posited last week, I see an environment hostile to speculative leverage. This ensures a fundamental tightening of financial conditions and attendant downward pressure on global asset markets – securities and real estate, in particular. And with Bernanke’s 40-year bond yield “ski slope” at the end of a historic run, central banks have today little capacity for using rate cuts to reflate asset prices.

The U.S. economy is in trouble. Europe is in greater trouble. EM economies face a disastrous combination of financial and economic hardship. And just as China moves to restart its economy, its massive export sector is confronting collapsing global demand.

How long Beijing can hold things together is a critical issue. In the theme of bursting Bubble economies and unfolding Solvency Problems, no country faces greater challenges than China (with its deeply maladjusted economy and gargantuan financial sector).

March 26 – Bloomberg (Matthew Boesler): “The Federal Reserve’s balance sheet topped $5 trillion for the first time amid the U.S. central bank’s aggressive efforts to cushion debt markets against the coronavirus outbreak through large-scale bond-buying programs. Total assets held by the Fed rose by $586 billion to $5.25 trillion in the week through March 25… Borrowing by banks from the Fed’s discount window jumped to $50.8 billion.

The central bank has rolled out several liquidity programs over the last few weeks to keep credit flowing… The scale of its current bond-buying efforts already dwarfs that of the purchase programs it undertook in the wake of the last financial crisis. The Fed is also expected to establish a Main Street Business Lending Program to provide help to smaller firms.

Borrowing under its Primary Dealer Credit Facility was $27.7 billion as of Wednesday, with the Money Market Mutual Fund Liquidity Facility standing at $30.6 billion. Borrowing by foreign central banks soared to $206 billion -- the highest since 2009 -- following the Fed’s March 19 announcement that it would expand dollar swap lines to a larger group of nations.”

Yuval Noah Harari: the world after coronavirus

This storm will pass. But the choices we make now could change our lives for years to come

Yuval Noah Harari

© Graziano Panfili

Humankind is now facing a global crisis. Perhaps the biggest crisis of our generation. The decisions people and governments take in the next few weeks will probably shape the world for years to come. They will shape not just our healthcare systems but also our economy, politics and culture. We must act quickly and decisively.

We should also take into account the long-term consequences of our actions. When choosing between alternatives, we should ask ourselves not only how to overcome the immediate threat, but also what kind of world we will inhabit once the storm passes. Yes, the storm will pass, humankind will survive, most of us will still be alive — but we will inhabit a different world.

Many short-term emergency measures will become a fixture of life. That is the nature of emergencies. They fast-forward historical processes. Decisions that in normal times could take years of deliberation are passed in a matter of hours. Immature and even dangerous technologies are pressed into service, because the risks of doing nothing are bigger. Entire countries serve as guinea-pigs in large-scale social experiments.

What happens when everybody works from home and communicates only at a distance? What happens when entire schools and universities go online? In normal times, governments, businesses and educational boards would never agree to conduct such experiments. But these aren’t normal times.

In this time of crisis, we face two particularly important choices. The first is between totalitarian surveillance and citizen empowerment. The second is between nationalist isolation and global solidarity.

Under-the-skin surveillance

In order to stop the epidemic, entire populations need to comply with certain guidelines. There are two main ways of achieving this. One method is for the government to monitor people, and punish those who break the rules. Today, for the first time in human history, technology makes it possible to monitor everyone all the time.

Fifty years ago, the KGB couldn’t follow 240m Soviet citizens 24 hours a day, nor could the KGB hope to effectively process all the information gathered. The KGB relied on human agents and analysts, and it just couldn’t place a human agent to follow every citizen. But now governments can rely on ubiquitous sensors and powerful algorithms instead of flesh-and-blood spooks.

       The Colosseum in Rome

     Piazza Beato Roberto in Pescara © Graziano Panfili

In their battle against the coronavirus epidemic several governments have already deployed the new surveillance tools. The most notable case is China. By closely monitoring people’s smartphones, making use of hundreds of millions of face-recognising cameras, and obliging people to check and report their body temperature and medical condition, the Chinese authorities can not only quickly identify suspected coronavirus carriers, but also track their movements and identify anyone they came into contact with. A range of mobile apps warn citizens about their proximity to infected patients.
 This kind of technology is not limited to east Asia. Prime Minister Benjamin Netanyahu of Israel recently authorised the Israel Security Agency to deploy surveillance technology normally reserved for battling terrorists to track coronavirus patients. When the relevant parliamentary subcommittee refused to authorise the measure, Netanyahu rammed it through with an “emergency decree”.

You might argue that there is nothing new about all this. In recent years both governments and corporations have been using ever more sophisticated technologies to track, monitor and manipulate people. Yet if we are not careful, the epidemic might nevertheless mark an important watershed in the history of surveillance. Not only because it might normalise the deployment of mass surveillance tools in countries that have so far rejected them, but even more so because it signifies a dramatic transition from “over the skin” to “under the skin” surveillance.

Hitherto, when your finger touched the screen of your smartphone and clicked on a link, the government wanted to know what exactly your finger was clicking on. But with coronavirus, the focus of interest shifts. Now the government wants to know the temperature of your finger and the blood-pressure under its skin.

The emergency pudding

One of the problems we face in working out where we stand on surveillance is that none of us know exactly how we are being surveilled, and what the coming years might bring. Surveillance technology is developing at breakneck speed, and what seemed science-fiction 10 years ago is today old news.

As a thought experiment, consider a hypothetical government that demands that every citizen wears a biometric bracelet that monitors body temperature and heart-rate 24 hours a day. The resulting data is hoarded and analysed by government algorithms. The algorithms will know that you are sick even before you know it, and they will also know where you have been, and who you have met.

The chains of infection could be drastically shortened, and even cut altogether. Such a system could arguably stop the epidemic in its tracks within days. Sounds wonderful, right?

The downside is, of course, that this would give legitimacy to a terrifying new surveillance system. If you know, for example, that I clicked on a Fox News link rather than a CNN link, that can teach you something about my political views and perhaps even my personality. But if you can monitor what happens to my body temperature, blood pressure and heart-rate as I watch the video clip, you can learn what makes me laugh, what makes me cry, and what makes me really, really angry.

It is crucial to remember that anger, joy, boredom and love are biological phenomena just like fever and a cough. The same technology that identifies coughs could also identify laughs. If corporations and governments start harvesting our biometric data en masse, they can get to know us far better than we know ourselves, and they can then not just predict our feelings but also manipulate our feelings and sell us anything they want — be it a product or a politician.

Biometric monitoring would make Cambridge Analytica’s data hacking tactics look like something from the Stone Age. Imagine North Korea in 2030, when every citizen has to wear a biometric bracelet 24 hours a day. If you listen to a speech by the Great Leader and the bracelet picks up the tell-tale signs of anger, you are done for.

You could, of course, make the case for biometric surveillance as a temporary measure taken during a state of emergency. It would go away once the emergency is over. But temporary measures have a nasty habit of outlasting emergencies, especially as there is always a new emergency lurking on the horizon.

My home country of Israel, for example, declared a state of emergency during its 1948 War of Independence, which justified a range of temporary measures from press censorship and land confiscation to special regulations for making pudding (I kid you not). The War of Independence has long been won, but Israel never declared the emergency over, and has failed to abolish many of the “temporary” measures of 1948 (the emergency pudding decree was mercifully abolished in 2011).

Even when infections from coronavirus are down to zero, some data-hungry governments could argue they needed to keep the biometric surveillance systems in place because they fear a second wave of coronavirus, or because there is a new Ebola strain evolving in central Africa, or because . . . you get the idea. A big battle has been raging in recent years over our privacy.

The coronavirus crisis could be the battle’s tipping point. For when people are given a choice between privacy and health, they will usually choose health.

The soap police

Asking people to choose between privacy and health is, in fact, the very root of the problem.

Because this is a false choice. We can and should enjoy both privacy and health. We can choose to protect our health and stop the coronavirus epidemic not by instituting totalitarian surveillance regimes, but rather by empowering citizens. In recent weeks, some of the most successful efforts to contain the coronavirus epidemic were orchestrated by South Korea, Taiwan and Singapore. While these countries have made some use of tracking applications, they have relied far more on extensive testing, on honest reporting, and on the willing co-operation of a well-informed public.

Centralised monitoring and harsh punishments aren’t the only way to make people comply with beneficial guidelines. When people are told the scientific facts, and when people trust public authorities to tell them these facts, citizens can do the right thing even without a Big Brother watching over their shoulders. A self-motivated and well-informed population is usually far more powerful and effective than a policed, ignorant population.

Consider, for example, washing your hands with soap. This has been one of the greatest advances ever in human hygiene. This simple action saves millions of lives every year. While we take it for granted, it was only in the 19th century that scientists discovered the importance of washing hands with soap.

Previously, even doctors and nurses proceeded from one surgical operation to the next without washing their hands. Today billions of people daily wash their hands, not because they are afraid of the soap police, but rather because they understand the facts. I wash my hands with soap because I have heard of viruses and bacteria, I understand that these tiny organisms cause diseases, and I know that soap can remove them.

But to achieve such a level of compliance and co-operation, you need trust. People need to trust science, to trust public authorities, and to trust the media. Over the past few years, irresponsible politicians have deliberately undermined trust in science, in public authorities and in the media. Now these same irresponsible politicians might be tempted to take the high road to authoritarianism, arguing that you just cannot trust the public to do the right thing.

Normally, trust that has been eroded for years cannot be rebuilt overnight. But these are not normal times. In a moment of crisis, minds too can change quickly. You can have bitter arguments with your siblings for years, but when some emergency occurs, you suddenly discover a hidden reservoir of trust and amity, and you rush to help one another. Instead of building a surveillance regime, it is not too late to rebuild people’s trust in science, in public authorities and in the media.

We should definitely make use of new technologies too, but these technologies should empower citizens. I am all in favour of monitoring my body temperature and blood pressure, but that data should not be used to create an all-powerful government. Rather, that data should enable me to make more informed personal choices, and also to hold government accountable for its decisions.

If I could track my own medical condition 24 hours a day, I would learn not only whether I have become a health hazard to other people, but also which habits contribute to my health.

And if I could access and analyse reliable statistics on the spread of coronavirus, I would be able to judge whether the government is telling me the truth and whether it is adopting the right policies to combat the epidemic. Whenever people talk about surveillance, remember that the same surveillance technology can usually be used not only by governments to monitor individuals — but also by individuals to monitor governments.

The coronavirus epidemic is thus a major test of citizenship. In the days ahead, each one of us should choose to trust scientific data and healthcare experts over unfounded conspiracy theories and self-serving politicians. If we fail to make the right choice, we might find ourselves signing away our most precious freedoms, thinking that this is the only way to safeguard our health.

We need a global plan

The second important choice we confront is between nationalist isolation and global solidarity. Both the epidemic itself and the resulting economic crisis are global problems. They can be solved effectively only by global co-operation.

First and foremost, in order to defeat the virus we need to share information globally. That’s the big advantage of humans over viruses. A coronavirus in China and a coronavirus in the US cannot swap tips about how to infect humans.

But China can teach the US many valuable lessons about coronavirus and how to deal with it.

What an Italian doctor discovers in Milan in the early morning might well save lives in Tehran by evening. When the UK government hesitates between several policies, it can get advice from the Koreans who have already faced a similar dilemma a month ago. But for this to happen, we need a spirit of global co-operation and trust.

Countries should be willing to share information openly and humbly seek advice, and should be able to trust the data and the insights they receive. We also need a global effort to produce and distribute medical equipment, most notably testing kits and respiratory machines. Instead of every country trying to do it locally and hoarding whatever equipment it can get, a co-ordinated global effort could greatly accelerate production and make sure life-saving equipment is distributed more fairly. Just as countries nationalise key industries during a war, the human war against coronavirus may require us to “humanise” the crucial production lines.

A rich country with few coronavirus cases should be willing to send precious equipment to a poorer country with many cases, trusting that if and when it subsequently needs help, other countries will come to its assistance.

We might consider a similar global effort to pool medical personnel. Countries currently less affected could send medical staff to the worst-hit regions of the world, both in order to help them in their hour of need, and in order to gain valuable experience. If later on the focus of the epidemic shifts, help could start flowing in the opposite direction.

Global co-operation is vitally needed on the economic front too. Given the global nature of the economy and of supply chains, if each government does its own thing in complete disregard of the others, the result will be chaos and a deepening crisis. We need a global plan of action, and we need it fast.

Another requirement is reaching a global agreement on travel. Suspending all international travel for months will cause tremendous hardships, and hamper the war against coronavirus.

Countries need to co-operate in order to allow at least a trickle of essential travellers to continue crossing borders: scientists, doctors, journalists, politicians, businesspeople. This can be done by reaching a global agreement on the pre-screening of travellers by their home country. If you know that only carefully screened travellers were allowed on a plane, you would be more willing to accept them into your country.

Unfortunately, at present countries hardly do any of these things. A collective paralysis has gripped the international community. There seem to be no adults in the room. One would have expected to see already weeks ago an emergency meeting of global leaders to come up with a common plan of action. The G7 leaders managed to organise a videoconference only this week, and it did not result in any such plan.

In previous global crises — such as the 2008 financial crisis and the 2014 Ebola epidemic — the US assumed the role of global leader. But the current US administration has abdicated the job of leader. It has made it very clear that it cares about the greatness of America far more than about the future of humanity.

This administration has abandoned even its closest allies. When it banned all travel from the EU, it didn’t bother to give the EU so much as an advance notice — let alone consult with the EU about that drastic measure. It has scandalised Germany by allegedly offering $1bn to a German pharmaceutical company to buy monopoly rights to a new Covid-19 vaccine.

Even if the current administration eventually changes tack and comes up with a global plan of action, few would follow a leader who never takes responsibility, who never admits mistakes, and who routinely takes all the credit for himself while leaving all the blame to others.

If the void left by the US isn’t filled by other countries, not only will it be much harder to stop the current epidemic, but its legacy will continue to poison international relations for years to come. Yet every crisis is also an opportunity. We must hope that the current epidemic will help humankind realise the acute danger posed by global disunity.

Humanity needs to make a choice. Will we travel down the route of disunity, or will we adopt the path of global solidarity? If we choose disunity, this will not only prolong the crisis, but will probably result in even worse catastrophes in the future.

If we choose global solidarity, it will be a victory not only against the coronavirus, but against all future epidemics and crises that might assail humankind in the 21st century.

Yuval Noah Harari is author of ‘Sapiens’, ‘Homo Deus’ and ‘21 Lessons for the 21st Century’

Markets contemplate a future in which stimulus does not work

Wall Street’s plunge underlines Fed’s diminishing ability to limit shockwaves

Gillian Tett

This decade, America’s equity market has been like a drug addict. Until 2008, investors were hooked on monetary heroin (ie a private sector credit bubble).

Then, when that bubble burst, they turned to the financial equivalent of morphine (trillions of dollars of central bank support).

Now, in the wake of Thursday’s historic equity market crash, they must contemplate a scary question: has this monetary morphine ceased to work?

Think about it. Ever since 2016, the Federal Reserve has tried to wean the markets off its quantitative easing measures and ultra-low rates. But whenever markets have wobbled — as they did last year in the repurchase sector — the Fed always returned with a new monetary fix.

That has helped to sustain a startling bull market in equities and bonds.

Last week initially seemed a replay of this pattern: after equity markets tumbled, the Fed delivered a 50 basis point emergency cut. There was an immediate jump just after the rate cut — by 500 points for the Dow Jones Industrial Average — but it fell later that day.

And this week the respite from a Fed hit was even more shortlived: on Thursday it pledged new asset purchases and $1.5tn support for repo markets but after a brief rally, equity prices crashed again, closing almost 10 per cent down. This is the fifth-largest daily decline on record — which is chilling given that the four other episodes were 1987 and the three worst days in 1929. 
If you want to be optimistic, it is possible to argue (or hope) that the magnitude of Thursday’s crash can be partly blamed on the pesky robots. An ever-swelling proportion of the market is traded according to computer-driven strategies, and these unleash waves of automatic selling (or buying) when technical levels are breached, fuelling volatility.

The swings were probably further amplified because some asset managers engaged in forced selling to meet margin calls, creating pockets of bizarre price swings. Take gold. Normally this rallies in a crisis. But on Thursday it tumbled more than 5 per cent. This is a hint that somebody was selling whatever assets they had to hand that were liquid and valuable.

And if you want to be truly cheerful it is also possible to think — or hope — that the sheer magnitude of Thursday’s share price crash has actually created the seeds of its future reversal. After all, one thing we have learnt from President Donald Trump’s tweets is that he is obsessed with the stock market (which is no surprise, perhaps, given how closely it correlates it to his approval rating).

A graphic with no description

It is possible that a 10 per cent market crash is the one thing that will force Mr Trump to acknowledge the severity of the coronavirus crisis and force him to back proper responses to contain it (free mass-testing and more controls on movement). If that emerges in the coming days, it will cheer investors.

However, there is another way to interpret Thursday’s dramatic moves: investors may be starting to contemplate a world in which financial morphine no longer functions. After all, another startling detail about Thursday’s drama was that the yield on 10-year bonds rose to 0.88 per cent, compared with 0.76 per cent two days earlier.

This is alarming — and odd — given the Fed support announcement on Thursday; doubly so, since Wall Street analysts now predict that the US central bank will cut rates to zero next week.

Maybe this can be blamed on more forced selling (there are rumours of hedge funds engaged in relative value strategies being forced to unwind positions in a manner that distorts bond prices).

But it might also reflect something else: some investors no longer think that a shot of cheap money works in the face of medical uncertainty, a global recession, looming corporate defaults and weak political leadership.

Either way, the key point is this: Thursday’s crash not only pushed March 12 2020 into the history books; it also undermined the image of central bank omnipotence.

If President Trump thinks he can reverse the rout by demanding more Fed action, he is gravely mistaken. Prepare for more market spasms.

Coronavirus Sparks a Global Gold Rush

Epic shortage spooks doomsday preppers and bankers alike; ‘Unaffordium and unobtanium’

     Gold bars stacked in a vault at the U.S. Mint, in West Point, N.Y., in 2014. MIKE GROLL/ASSOCIATED PRESS

It’s an honest-to-God doomsday scenario and the ultimate doomsday-prepper market is a mess.

As the coronavirus pandemic takes hold, investors and bankers are encountering severe shortages of gold bars and coins. Dealers are sold out or closed for the duration. Credit Suisse Group AG, which has minted its own bars since 1856, told clients this week not to bother asking. In London, bankers are chartering private jets and trying to finagle military cargo planes to get their bullion to New York exchanges.

It’s getting so bad that Wall Street bankers are asking Canada for help. The Royal Canadian Mint has been swamped with requests to ramp up production of gold bars that could be taken down to New York.

With staff reduced at the Royal Canadian Mint because of the virus, the government-owned company is only producing one variation of bullion bars, according to Amanda Bernier, a senior sales manager. She said the mint has received “unprecedented levels of demand,” largely from U.S. banks and brokers.

The price of gold futures rose about 9% to roughly $1,620 a troy ounce this week—that is 31.1034768 grams, per the U.K. Royal Mint—and neared a seven-year high. Only on a handful of occasions since 2000 have gold prices risen more in a single week, including immediately after Lehman Brothers filed for bankruptcy in September 2008.

“When people think they can’t get something, they want it even more,” says George Gero, 83, who’s been trading gold for more than 50 years, now at RBC Wealth Management in New York. “Look at toilet paper.”

Worth its weight in Purell

Gold has been prized for thousands of years and today goes into items ranging from jewelry to dental crowns to electronics. For decades, the value of paper money was pinned to gold; tons of it sat in Fort Knox to reassure Americans their dollars were worth something. Today they just have to trust. President Nixon unpegged the dollar from gold in 1971.

The government still holds lots of gold in Fort Knox, though not as much as it did decades ago. The Federal Reserve Bank of New York has a massive gold stash. That gold isn’t released on the open market, though; it’s held as national reserve. London is the hub of physical gold trading that often changes hands.

Gold is popular with survivalists and conspiracy theorists but it is also a sensible addition to investment portfolios because its price tends to be relatively stable. It is especially in-demand during economic crises as a shield against inflation. When the Federal Reserve floods the economy with cash, like it is doing now, dollars can get less valuable.

“Gold is the one money that can’t be printed,” said Roy Sebag, CEO of Goldmoney Inc., which has one of the world’s largest private stashes, worth about $2 billion. (He’d rather not say where, for obvious reasons.)

There are two ways to own gold: in bars or coins or jewelry stored in bank vaults, or in futures contracts traded on an exchange, which guarantee the holder a certain amount of gold at a certain price on a certain date.

Those contracts trade on CME Group Inc.’s Comex division of the New York Mercantile Exchange. The problem? Much of the world’s gold is in London and has been since the 17th century, when the Bank of England set up a vault. 

The Bank of England holds much of the world’s gold. PHOTO: HENRY NICHOLLS/REUTERS

Today, the Bank of England says it has the second-largest collection of gold in its vault, behind only the New York Fed.

The disruptions this week pushed the gold futures price, on the New York exchange, as much as $70 an ounce above the price of physical gold in London. Typically, the two trade within a few dollars of each other.

That gulf sparked a high-stakes game of chicken in the New York futures market this week. Sharp-eyed traders started snapping up physical delivery contracts, figuring banks would have trouble finding enough gold to make good and they would be able to squeeze them for cash. That set off a scramble by banks.

Goldmoney’s Mr. Sebag said bankers were offering him $100 or more per ounce over the London price to get their hands on some of his New York gold.

Wade Brennan, a former gold trader at Scotiabank who now runs an investment firm called Kilo Capital, said he had heard from bankers in the U.S. who were literally checking the corners of their vaults for any gold that might have been overlooked.

“Everyone’s looking through the cupboard,” he said.

As of November, London housed 8,263 metric tons of gold, valued at $387.9 billion, according to the London Bullion Market Association. The biggest hoard is kept by the Bank of England, which looks after around 400,000 gold bars on behalf of the U.K. government, commercial banks and central banks in other countries, hidden in nine vaults under the narrow streets of the City of London.

Getting gold to New York, where it can be sent on to gold dealers, jewelers, dentists and electronics makers, is a heavy lift in the best of times, and, it turns out, quite tricky during a pandemic.

Most gold bars are stowed in the cargo hold of passenger planes. Security firms such as Loomis Group, which arrange the flights and meet planes on the tarmac, don’t like to move more than about five tons on any flight, in case the plane crashes and because of high insurance costs. From there, the haul is trucked under heavy guard to New York warehouses.

International flights are largely grounded now.

What’s more, there is limited new supply. Mines in countries such as Peru and South Africa are also shut down because of the coronavirus. Once-busy Swiss refineries that turn raw metal into gold bars closed earlier this week as the country’s coronavirus cases neared 10,000.

There is still a lot of gold in the world, some $10 trillion worth, but “it’s not in the right place,” said Simon Mikhailovich, co-founder of the Bullion Reserve, which holds on to gold for investors.

David Smith owns a wristwatch business in northern England and said Tuesday his bullion dealers weren’t taking any more orders. He has been scouring social media for individuals who might sell to him.

“You can’t really get physical gold and silver anywhere at the moment,” he said.

He began investing personally in metals a few years ago after watching videos from Mike Maloney, creator of the website Like other online dealers, the site currently has a notice saying products are back-ordered up to 12 weeks and that there is a $1,000 delivery order minimum.

The title of Mr. Maloney’s latest podcast: “Unaffordium and unobtanium.” (The latter has popped up in the plots of science fiction movies).

Queen Elizabeth II views stacks of gold as she visits the Bank of England in London in 2012.

The Bank of England on Wednesday emailed banks that keep gold in its vault to reassure them it still had access to deliveries and airports. Bankers with gold vaults in Canary Wharf, on the city’s eastern edge, are worried by the closure of nearby London City Airport, a popular hopping-off point for flights that move gold to and from Switzerland and Luxembourg.

An employee inspects a Canadian one dollar coin, also known as a Loonie, at the Royal Canadian Mint manufacturing facility in 2019. PHOTO: SHANNON VANRAES/BLOOMBERG NEWS

For those able to deliver, though, there is big money to be made. In normal times, it costs around 20 cents to fly an ounce of gold, just under 20 cents to melt the bars down and refabricate them to match New York’s delivery standards, and another 10 cents or so in financing costs, according to a retired senior gold trader. (London bars are heavier than those in demand in New York.)

So if New York prices are $1 an ounce higher than in London, a bank can make $80,000 moving five metric tons of gold—almost risk-free.

At Tuesday’s prices, the same load would net $11 million in profit, minus the cost of chartering the jet.

——Anna Isaac, Jacquie McNish and Alistair MacDonald contributed to this article.

The Pandemic Stress Test

The COVID-19 crisis has exposed the underlying weaknesses in national economies, health systems, and even political ideologies. If there is any silver lining, it is that long-vilified experts and professionals have an opportunity to regain the public's trust.

Raghuram G. Rajan

rajan61_Jane Barlow - WPA PoolGetty Images_coronaviruslabtestscientist

CHICAGO – The coronavirus pandemic has taken the world by surprise and will now expose underlying economic weaknesses wherever they lie. But the crisis also reminds us that we live in a deeply interconnected world. If the pandemic has any silver lining, it is the possibility of a much-needed reset in public dialogue that focuses attention on the most vulnerable in society, on the need for global cooperation, and on the importance of professional leadership and expertise.

Apart from the direct impact on public health, a crisis of this magnitude can trigger at least two direct kinds of economic shock. The first is a shock to production, owing to disrupted global supply chains. Suspending the production of basic pharmaceutical chemicals in China disrupts the production of generic drugs in India, which in turn reduces drug shipments to the United States. The second shock is to demand: as people and governments take steps to slow the spread of the coronavirus, spending in restaurants, shopping malls, and tourist destinations collapses.

But there is also the potential for indirect aftershocks, such as the recent plunge in oil prices following Russia and Saudi Arabia’s failure to agree on coordinated output cuts. As these and other shocks propagate, already stressed small- and medium-size businesses could be forced to shut down, leading to layoffs, lost consumer confidence, and further reductions in consumption and aggregate demand.

Moreover, downgrades to, or defaults by, highly leveraged entities (shale-energy producers in the US; commodity-dependent developing countries) could lead to wider losses in the global financial system. That would curtail liquidity and credit, and trigger a dramatic tightening of the financial conditions that have hitherto been so supportive of growth.

The parade of horrible possibilities could go on. The more fundamental point to remember is that the world economy never fully recovered from the 2008 global financial crisis, nor were the underlying problems that produced that disaster ever fully addressed. On the contrary, governments, businesses, and households around the world have piled on more debt, and policymakers have undermined trust in the global trading and investment system.

But even though the world started with a weak hand, our response to the COVID-19 crisis could be far better than it has been. The immediate task is to limit the spread of the virus through widespread testing, rigorous quarantines, and social distancing. Most developed countries should be well-positioned to implement such measures; yet, Italy has been overwhelmed by the epidemic, and the US response has not exactly inspired confidence.

Looking ahead, unless the coronavirus is eradicated globally, it could always return, or even become a seasonal disruption. If an effective treatment is not discovered soon (Gilead’s antiviral drug remdesivir currently shows some promise), all countries will face a choice between walling themselves off entirely and pushing for a global effort to eradicate the virus. Given that the former is an impossibility, the latter seems the natural choice. But it would require a degree of global leadership and cooperation that is sorely lacking. The presidency of the G20 is currently held by Saudi Arabia, which is mired in internal and external disputes; and US President Donald Trump’s administration has repudiated multilateral action from the outset.

Still, some key countries could accomplish much if they stepped up to lead a global response, including by persuading more countries of the value of cooperation. For example, countries that have been relatively successful in managing the epidemic, such as China and South Korea, could share best practices. And as individual countries bring the coronavirus under control within their own borders, they could dispatch spare resources to countries that need more experienced medical personnel, respirators, testing kits, masks, and the like.

Moreover, China and the US might finally be cajoled into reversing recent tariff increases and dispensing with threats of new ones (such as on cars). While a temporary reduction in tariffs would do little to enhance cross-border investment, it would at least offer a slight boost to trade. Moreover, an accord could enhance business sentiment about the post-pandemic recovery.

Within countries, the immediate task – after implementing measures to contain the virus – is to support those in the informal or gig economy whose livelihoods will be disrupted by quarantines and social distancing. Those who are most vulnerable economically also tend to be those who lack access to medical care. Hence, at a minimum, governments should offer cash transfers to these individuals – or to everyone, if vulnerable populations are hard to identify – as well as coverage for virus-related medical expenses. Similarly, a moratorium on some tax payments may be necessary to help small- and medium-sized businesses, as would partial loan guarantees and other measures to keep credit flowing.

In developed countries, in particular, the pandemic will soon reveal just how many people have joined the ranks of the precariat in recent years. This cohort skews young and includes many of those living in “left-behind” places. By definition, the precariat’s members lack the skills or education needed to secure stable jobs with benefits, and thus have little stake in “the system.” Cash transfers would send a message that the system still cares. But, of course, far more will need to be done to expand the social safety net and extend new opportunities to the economically marginalized.

Populist parties and leaders have capitalized politically on the plight of the precariat, but they have failed to live up to their promises – even where they actually hold power. The pandemic may have a silver lining here, too.

Governments that have undermined established disaster-preparedness agencies and early-warning protocols are now finding that they need the professionals and experts after all. COVID-19 has been quick to expose amateurism and incompetence. If the professionals are allowed to do their jobs, they can restore some of the public’s lost trust in the establishment.

In the political arena, a more credible professional establishment will have an opportunity to advance sensible policies that address the problems facing the precariat without ushering in class warfare. But these openings won’t last forever. If the professionals fail to capitalize on them, the pandemic will offer no silver linings – only more dread, division, chaos, and misery.

Raghuram G. Rajan, former Governor of the Reserve Bank of India, is Professor of Finance at the University of Chicago Booth School of Business and the author, most recently, of The Third Pillar: How Markets and the State Leave the Community Behind.

When Black Swans Collide

by: The Heisenberg
- This week will be enshrined in the textbooks as one of the most dramatic stretches in modern market history.

- Understandably, everyone with even a passing interest in finance feels compelled to weigh in.

- Here is a Heisenberg explainer that touches on (almost) every important aspect of a truly breathtaking episode.

At some point on Friday evening, after declaring a national emergency in a bid to allay widespread concerns that the federal government is behind the curve in preparing for a public health crisis, Donald Trump sat down, pulled out a Sharpie, and autographed a copy of an intraday Dow chart.
He then sent it to Fox News host Lou Dobbs.
It's true that US equities finished the week with a bang, but to say it's too early to celebrate would be an early candidate for understatement of the year.
Consider that even after Friday's 9.3% rally (the largest one-day gain since the crisis years), US stocks still had their second worst week since the GFC. I probably don't need to tell you this, but the worst week for US equities since 2008 was the week before last. And, of course, the worst single-session since the 1987 crash came on Thursday.
As I put it Friday evening, "it says a lot about the week when a 9.3% Friday gain still leaves you with the second-worst week since the GFC."
These last five days represent the collision of two black swans, the coronavirus pandemic and an oil price war between Riyadh and Moscow.
That characterization (two black swans splashing down simultaneously and then colliding while swimming in the same pond) is underscored by some of the multi-standard-deviation moves witnessed this week.
Monday's change in CDX.IG (think of it as the "fear gauge" for US investment grade credit) was a 12-sigma event, for example. That widening is "contested only by the first day’s reaction to Lehman default (16-Sep-2008)," Deutsche Bank's Aleksandar Kocic wrote in a Wednesday note.
(Deutsche Bank)
Credit spreads ballooned wider this week, in recognition of rising recession odds, rekindling concerns about “fallen angel” risk in BBBs and exposing over-leveraged balance sheets to the biggest stress test since the crisis.
"The epicenter of new risk opened by the oil shock resides in credit," Deutsche's Kocic went on to remark, adding that "behind this reaction of credit lies the decomposition of the IG sector [where] BBB is the largest tranche accounting for about 40% of the entire investment grade universe."
You should note that over the course of the week, bond and credit ETFs showed signs of stress.
Have a look, for example, at an NAV premium/discount analysis for the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD):
(Bloomberg, through Thursday)
This is what I (and plenty of others) have warned about for years. Namely that, in a real pinch (where "real" means an actual crisis, not just a period of acute stress), some fixed income products could effectively break.
Bloomberg reluctantly covered this in an article dated Thursday (I'm employing some artistic license using the word "reluctantly" there, but the fact is, nobody wants to admit that the ETFs can "snap," so to speak). Here's an excerpt from Bloomberg's piece:
"The historic volatility roiling American bond markets has created unprecedented dislocations in the ETFs that track them. But the market makers who normally step in to repair price inconsistencies, pocketing a virtually risk-free profit, are cautious. That’s because their standard process has become significantly more complicated with many of their usual price gauges are out of whack."
These products promise intraday liquidity against a pool of underlying assets that are inherently less liquid. Over the years, I've repeatedly described that promise as "a philosophical impossibility."
The arbitrage mechanism that makes it possible on a daily basis will not work in a crisis, and due to the onerous post-GFC regulatory regime, the Street will not be willing to lend its balance sheet in a pinch.
This is complicated immeasurably by the fact that years of artificially suppressed borrowing costs have encouraged corporates to issue obscene amounts of debt, the proceeds from which are in some cases funneled into share buybacks, in a loop that drives stocks inexorably higher, but leaves the corporate sector over-leveraged.
In addition to all the normal concerns about too much leverage, the situation is made more precarious still by the disconnect between the mountain of outstanding corporate debt and Wall Street's capacity to warehouse it.
Here's a visualization:
(Heisenberg, Bloomberg, NY Fed, Deutsche Bank)
The setup described above simply cannot work in a crisis or a firesale scenario.
As I've repeatedly stressed when discussing this since 2016 (and long before that in my "pre-Heisenberg" existence), I am not making a "doomsday" prediction or otherwise suggesting that anyone sell anything (or buy anything to hedge against a credit apocalypse).
All I am saying (and all I have ever said on this subject) is that the whole setup is based on liquidity transformation. The only kind of liquidity transformation that "works" infallibly is fractional reserve banking in countries where the government guarantees deposits.
Any other kind of liquidity transformation is philosophically impossible. Although it can be mitigated by a variety of intervening mechanisms (one of which has been severely constricted for years as shown in the chart), it will cease to function in a true crisis absent a government guarantee. Period.
That is (quite literally) all there is to this discussion, which is why I quit having it years ago. It's not debatable. Anyone who tells you different is telling you the sky isn't blue. They are right on cloudy days, but ultimately, they are wrong. Here's Bloomberg to explain what happened this week (from the same article linked above):

"It’s not uncommon for an ETF to drop below its net-asset value -- but it is unusual to see a continuation of that. In normal market environments, such a decline presents an arbitrage opportunity for certain middlemen known as authorized participants.  
Typically market markers will buy shares of the ETF as its price drops and redeem these shares with the issuer in return for the underlying bonds. The authorized participant will then sell those securities to capture a relatively risk-free profit. By reducing the supply of ETF shares, the fund’s price typically returns to tracking the fund’s net asset value. 
But as the coronavirus outbreak unleashes historical turbulence in financial markets and liquidity dries up, ETFs spanning the bond spectrum are trading at steep discounts. That dynamic will likely persist until volatility subsides and market makers have a better sense of where they can sell the underlying debt, according to UBS Global Wealth Management’s David Perlman."

I want to make an absolutely crucial point here which I also drove home on Twitter during a brief exchange with Bloomberg's ETF expert. None of the above is to suggest that anyone in the industry is doing anything "wrong" by offering these products.
They are absolutely safe in almost any market environment imaginable outside of a true meltdown, and these vehicles (the "normal" ones, that is - I'm not talking about levered products) will likely make it out of this pinch just fine.
So, please, before anyone criticizes me for being a fixed income ETF doomsayer, at least acknowledge that latter paragraph.
But it wasn't just credit ETFs. It was also bond ETFs. I'm not sure how many readers here are aware of this, but the Treasury market effectively stopped functioning this week. That's a gross oversimplification, but suffice to say that disconnects between cash versus futures and myriad dislocations showed up on Tuesday, Wednesday and Thursday, setting off a near incessant stream of chatter about basis widening and what were almost surely all manner of RV blowups.
"20bps+ swings [are] now becoming standard, particularly within the off-the-run space which are trading miles wide due to balance sheet dynamics, with no more dealer capacity and RV guys unwinding into clear stop-out trades," Nomura's Charlie McElligott wrote Thursday.
“Relative value — historically a very profitable, highly leveraged strategy — relationships have frayed to the point of incredulity, indicating high levels of distress,” Bloomberg's Cameron Crise said, during a long series of posts. "You don’t need to know what an invoice spread is… to see that the relationship between the long bond and ultras has gone badly, badly awry," he added.
This is one of the reasons the Fed stepped in on Thursday with a "bazooka," in the form of massive new repos and an announcement that the $60 billion/month in purchases aimed at restoring excess reserves would no longer be confined to T-Bills. Friday found the Fed buying across the curve. That's what the New York Fed meant Friday, when they said, in a statement, that purchases were being made "to address temporary disruptions in the market for Treasury securities."
Fed liquidity actions “were introduced in an attempt to offset the obvious liquidity strains in the ‘frozen’ Rates space, as evidenced by the moves in basis/off-the-runs this week,” McElligott said, adding that in order to mitigate the situation further and otherwise allay concerns, the Fed may well expand QE next week. Note that as of Thursday's announcement that purchases will no longer be confined to T-Bills, we are now back in QE in the United States. They're buying coupons.
As for the repos, there's a dollar-funding squeeze afoot, which manifested this week in further widening in FRA/OIS and cross-currency basis. The Fed upsized repos twice during the first half of the week, once on Monday as global markets melted down amid the oil shock, and then again in Wednesday's schedule.
That was prior to firing the bazooka on Thursday. That morning (Thursday morning) both the Fed's 14-day operation and the newly added one-month action were oversubscribed. Every 14-day term operation since last month has been oversubscribed.
Do note that in addition to all of this, Treasurys also likely came under pressure from selling to cover losses in other assets (as did gold, which plunged on the week as positions were liquidated to meet margin calls in risk assets).
Simultaneous declines in bonds and stocks on Wednesday, and only meager gains for the latter during Thursday's equity rout, led to two consecutive sessions of massive losses for a simple portfolio holding the S&P and (TLT). Friday found such a portfolio rebounding sharply as the gains in equities offset losses in bonds.
That, in turn, brings up risk parity.
In the pair of posts I managed to pen for readers on this platform amid the chaos, I outlined the role played by CTAs, option hedging (gamma) and vol.-targeting funds in exacerbating the rout.
Well, on Thursday, the risk parity kraken was finally released.
Bloomberg ran an article on this around lunchtime Thursday, but by then the genie was out of the bottle. The horse had left the barn. The ship had sailed.
Nomura’s model estimates aggregated gross exposure was cut "from 450% down to 305%" during the session or, from the 61st %ile to just the 2.9%ile (going back to 2011).
In the simplest possible terms, this is just another manifestation of the same "we're all momentum traders now" dynamic I've been so keen on emphasizing for the last couple of years.
These VaR shocks are catastrophic after a decade during which suppressed cross-asset volatility allowed for ever more leverage to be deployed across various asset classes. Some model-based, systematic deleveraging is faster-moving than others (e.g., trend/momentum strats impact the market rapidly, while vol.-targeting and risk parity deleverage on a delay as trailing realized gets pulled higher), but the bottom line for everyday, fundamental/ discretionary investors is this: Now you understand why this ostensible quant-ish "arcana" matters.
Going forward, one thing is certain: The coronavirus news will continue to dominate the tape.
As Pepperstone Group’s Chris Weston remarked, shortly after Trump's ill-fated Oval Office address on Wednesday evening, "investors will not hesitate to show what they think to the Fed and governments" when it comes to the perceived adequacy of the monetary and fiscal policy response.
The US economy is probably headed for a recession - even if it proves shallow. You should note that contrary to some headlines I've seen, Wall Street was not totally behind the curve on this. Deutsche Bank called for a global recession and a bear market on March 2.
Since November, SocGen's base case has been a US recession in Q2/Q3 2020. BNP's base case for the US economy in 2020 (outlined more than four months ago) was the furthest thing from ebullient. Nomura has been exceptionally cautious nearly from the very first headlines out of China about COVID-19. And I could go on.
The point is: Suggesting that Wall Street economists and analysts have totally missed the boat on how the virus would impact the global economy or suggesting that no Wall Street bank predicted a US recession in 2020 are manifestly false claims.
And I don't need to rely on my interpretation of mainstream media articles to say that. I have the original notes, with the timestamps including the day, hour, and minute (literally) that the notes were distributed. Those are the facts. Anything else you read is speculation.
The Fed will likely cut rates by 100bps next week. In my opinion, they'll probably up monthly asset purchases as well. Between the existing $60 billion/month for "reserve management" (and you can just toss that talking point out the window now), reinvestments and, let's just call it another $50 billion on top (that would be a nice round number for the Fed to add), we could see the Fed buying in excess of $120 billion/month in assets going forward, with rates basically back at the lower bound.
So, if you were wondering what happens when two black swans collide, the answer is: "All of the above."