The global economy was stared into the abyss on March 16, 2020. COVID-19 had sent country after country into lockdown, disrupting manufacturing supply chains and service sectors. Global US dollar liquidity had dried up and recession risks were skyrocketing. In Europe, corporate credit default swaps are traded with a probability of default of around 38%. What confirmed COVID-19 cases skyrocketed from fewer than 10 in January to nearly 165,000scientists desperately speculated about mortality and transmission rates.
Meanwhile, market participants were on tenterhooks. When the feeling turned from worry to panic, the collapse began. The Dow Jones ended the day down nearly 3,000 points. The S&P 500 fell 12% and the NASDAQ fell 12.3%. It was him The worst day for US stock markets since Black Monday 1987.
Repeating its Global Financial Crisis (GFC) playbook, the US Federal Reserve sought to calm markets and extended immediate liquidity to avoid a pandemic-induced cross-market ripple effect. Before the market opened on March 16, 2020, the Fed agreed swap-line agreements with five other central banks in an effort to ease pressure on the global supply of credit. A few days later, the Federal Reserve entered into similar agreements with nine other central banks.
But it was not enough. Before the end of March, the Fed expanded its provisions to even more central banks holding US Treasuries, Saudi Arabia among them. These central banks could temporarily swap their securities held with the Fed to access immediate funding in US dollars so they don’t have to liquidate their Treasuries.
Liquidity support for US dollar borrowers will always be an option for the Federal Reserve. Such interventions show that the central bank is committed to easing concerns about economic instability and protecting the economy from financial meltdown. Short term.
But, and in the long term? Does this quick and often predictable action increase the vulnerability of the financial system? Does it create moral hazard for central banks and market participants?
The state an economy is in when a crisis occurs is important. Thanks to tighter regulation and the evolving Basel Accords, today’s banks are more resilient and better capitalized than before the GFC. They are not the main concern. But the economy is more in debt and even more vulnerable to shocks. In 2020, total global debt soared at a rate not seen since World War II amid massive monetary stimulus. By the end of 2021, global debt had reached a record $303 billion.
This excess debt has created greater systemic risk, especially amid the recent rise in interest rates. Businesses gorged themselves on credit during the easy money era. Safe in the knowledge that policymakers would intervene in turbulent times, they failed to create a margin of safety.
The recent market volatility, the brutal clashes between bulls and bears, has been fueled by speculation about what the Fed will do next. The back-and-forth has often been repeated this year: Bad economic news has bulls running anticipating a possible Fed pivot to smaller increases, while strong GDP growth or jobs numbers feed bears, raising the odds that the Fed will stick to its guns Now, as the December FOMC meeting approaches, stock markets have caught a bid again with high hopes of a pivot.
The Fed raised rates for the first time last March, so the current rate hike cycle is not even a year old. However, indebted companies are already showing stress. How many more walks can they take and for how long? Preventing runaway inflation is essential, but so is addressing the inevitable consequences through carefully crafted fiscal policies that take the whole economy into account.
As investment professionals, we have to anticipate the long-term challenge. Today, the threat is clear: the higher interest rate environment will expose financially leveraged corporations. That means that risk management has to be among our top priorities and we have to hedge the interest rate hike cycle. Active asset and liability management requires us to look beyond the accounting impact and focus on the economic value of capital, among other metrics.
The bottom line is that in the midst of economic turmoil, the solution to the imminent threat often creates more significant long-term dangers. We should avoid speculating on when or if central banks or regulators will intervene. We must also remember that just as each economic downturn has unique causes, they also have unique cures.
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All messages are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image courtesy of the US Federal Reserve.
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Muadh Alhusaini, CFA, FRM, CAIA
