Via Damein Boey at Credit Suisse:
At times like this, we can’t help but draw from the wisdom of cinema. Consider the following quote from Aragorn (played by Viggo Mortensen) from “The Lord of the Rings: The Return of the King” (2003):
“I see in your eyes the same fear that would take the heart of me. A day may come when the courage of men fails, when we forsake our friends and break all bonds of fellowship, but it is not this day.”
Overnight, central bankers pulled out some more desperate measures to try to save the financial system from illiquidity. In particular, the Fed re-launched its commercial paper purchasing facility (CPPF) from the global financial crisis (GFC) days.
Essentially, the Fed stands ready to repurchase high quality commercial paper in secondary markets from non-financial participants, in exchange for emergency liquidity. It will do this indirectly through a special purpose investment vehicle, partly backed by the US Treasury. Also, it will lend at 200bps above the overnight indexed swap rate, well above the 100bps charge during the GFC. But considering that the Fed has just dropped the Fed funds rate by 100bps, all that the it is doing is charging the rate from a week ago. Presumably, the 100bps increase in spread reflects the Fed’s desire to only fund non-financial corporates through the CPPF window, rather than banks and primary dealers. These financial entities, in a pinch, will still need to go through the Fed’s discount window – an emergency window with a stigma attached. Reflecting the limited nature of the CPPF, we have seen interbank, and money market liquidity spreads continue to widen. But no doubt, the Fed has more tricks up its sleeve to fix the broken plumbing of the system, and is preparing to announce these in short order.
Returning the CPPF, it is interesting to note what it does, and what it does not do. It does help to reduce refinancing risk for corporates, because non-financial entities that would otherwise lend to corporates now have become liquefied by the Fed, and are not frozen. And this plumbing fix matters, because the system needs ample time and liquidity to be able to contend with the COVID-19 shock, without a surge in bad debts and foreclosures. However, the CPPF does not constitute the Fed lending directly to corporates, and bypassing the banks. The banks are still the primary intermediaries for financing the economy, and the Fed is actively encouraging them to lend in difficult times.
Many commentators, including Credit Suisse’s own money markets expert Zoltan Pozsar, believe that the CPPF does not go far enough. It does not relieve any binding constraints on money funds at the epicentre of the crisis. Nor does it actually constitute direct financing of corporates by the central bank. Therefore, it is an indirect support for distressed corporates during the shutdown period, at best. Interestingly, the BoJ has already “gone there” recently by setting up a direct corporate lending facility in its recent easing package. But the Fed requires a constitutional change before it can purchase or directly finance corporate assets …
Pozsar also is disappointed that the Fed has not yet established foreign exchange (FX) swap lines with non-G5 central banks. Currently, the ECB, BoJ, BoE, SNB and BoC are able to lend USDs to those needing them in their jurisdictions, via a line of (USD) credit with the Fed. But given the breadth of the COVID-19 crisis, other central banks need to be included in this privilege, especially those in Asia.
Again, we are reasonably optimistic that whatever is necessary will be done. Indeed, now more than ever, there is no pre-set course for monetary policy, in the sense that easing announcements can occur at any time. We are also reasonably optimistic that momentum reversal and cyclical exposures are the ones to pursue, whether you believe that the bottom is in, or that crowded defensive trades need to unwind in illiquid conditions. However, we cannot help but feel that something is not entirely right here …
Here is a longer term risk to consider, over and above the tactical. Central banks are central banks for a reason. They are supposed to sit (hide) behind commercial banks, so that the commercial banks take all the risk – not them. But the opening and widening of FX swap lines means that central banks are now taking on foreign currency credit exposure – that is, the credit risk of other central banks due to currency mis-matches. And the prospect of direct financing of corporates means that central banks are starting to take on genuine corporate credit risk. All in all, central bank balance sheets are becoming riskier to accommodate the de-risking of the private sector. But what happens when everything blows up again? Do central banks literally go bust?
Either they do, and we worry about the integrity of fiat currency systems, or they don’t because they print money to cover losses (effectively in collaboration with sovereigns, as they remit losses back to them, contributing to fiscal deficits, which in turn need more central bank financing). Either way, we worry about the integrity of fiat currency, or inflation. Therefore, attention starts to turn to alternative currency regimes, whether gold, or digital, or all of the above.
Today may not be the day when the courage of investors fails. But there will come a time when it will.
The full Pozsar note is here.