From meltdown to meltup. The Greenspan Put, the Bernanke Put, and the Yellen Put all resulted from actions taken by the Fed under those three Fed chairs to give stock prices a boost when they seemed to need it to avert a meltdown. The Powell Put saved the day in late 2018 when the Fed chair started to pivot away from raising the federal funds rate in 2019 to actually lowering it three times instead. The S&P 500 soared 44.0% from December 24, 2018 to a record high on February 19, 2020. On March 11, the World Health Organization declared that the COVID-19 outbreak had turned into a global pandemic. The pandemic of fear spread just as rapidly in the US capital markets, especially in the bond markets, which seized up as credit-quality yield spreads soared. On Sunday, March 15, the Fed
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On March 11, the World Health Organization declared that the COVID-19 outbreak had turned into a global pandemic. The pandemic of fear spread just as rapidly in the US capital markets, especially in the bond markets, which seized up as credit-quality yield spreads soared.
On Sunday, March 15, the Fed responded by cutting the federal funds rate by 100bps to zero and announcing a $700 billion QE4 program of Treasury and mortgage-backed securities purchases. That week, the governors of California and New York issued executive orders requiring nonessential workers to stay home. Credit-quality spreads continued to widen significantly. So on March 23, the Fed introduced QE4ever and posted term sheets on five major credit facilities.
Three of the new facilities dated back to the Great Financial Crisis and were reactivated. The big shockers were the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF). For the first time ever, the Fed was going to lend a hand to the investment-grade corporate bond market. On Monday, June 15, the Fed announced that the SMCCF would start buying corporate debt, and promised to activate the PMCCF soon, as discussed below.
In response to the Great Virus Crisis, Powell provided the biggest Fed put of them all, boosting both stock and corporate bond prices. The result has been to stop the 33.9% meltdown in the S&P 500, which lasted from February 19 through March 23. I'm not sure that deserves to be categorized as a bear market since it lasted only 23 trading days with declines exceeding 20% during only seven of those days! In any event, the meltdown was followed by a meltup with the S&P 500 soaring 44.5% through June 5.
The Fed's actions stopped the credit crunch and allowed corporations to raise piles of money at record low interest rates:
(2) Corporate bond issuance. Over the 12 months through April, nonfinancial corporations raised a record $1,175 billion. I estimate that at least half of that was used to refinance outstanding bonds (Fig. 3 and Fig. 4).
No asset left behind. The Fed is intent on offsetting the adverse impact on financial markets resulting from any flare up in the first wave of the viral pandemic or any second wave that might emerge after the first wave. The stock market sold off sharply last Thursday on fears that reopening the economy will lead to less social distancing triggering another wave of the virus. The market rebounded a bit on Friday, but then proceeded to fall again Monday morning on unsettling news over the weekend about rising cases of infection around the country.
Have no fear, the Fed is here with another wave of liquidity:
(1) Secondary facility is first. At 2:00 pm on Monday, the Fed released a press release with the following rather detailed headline, “Federal Reserve Board announces updates to Secondary Market Corporate Credit Facility (SMCCF), which will begin buying a broad and diversified portfolio of corporate bonds to support market liquidity and the availability of credit for large employers.”
The Fed announced that it was expanding its Secondary Market Corporate Credit Facility (SMCCF) to purchase individual corporate bonds to complement its current purchases of exchange-traded funds. This special purpose vehicle (SPV) is capitalized with $25 billion provided by the Treasury under the CARES Act, and can leverage that up by 10-to-1 to $250 billion.
But wait, there’s much more: The SPV includes the Primary Market Corporate Credit Facility (PMCCF), which will be able to leverage $50 billion in capital to purchase up to $500 billion in corporate bonds directly from issuers.
As part of its (almost) no-asset-left-behind (NALB) program, the SMCCF will purchase bonds rated BBB-/Baa3 (the lowest investment-grade category) as of March 22, 2020, but were subsequently downgraded to junk. Nevertheless, they must be rated at least BB-/Ba3 as of the date on which the facility makes a purchase. These so-called “fallen angels” accounted for 50% of outstanding investment-grade bonds before the virus hit the fan.
The SMCCF began purchasing eligible ETFs on May 12 and will begin purchasing corporate bonds on June 16. Purchases are expected to cease no later than September 30 of this year.
(2) Primary facility is second. The PMCCF is expected to become operational in the near future. Additional details on the PMCCF are forthcoming. It will provide companies access to credit by purchasing qualifying bonds as the sole investor in a bond issuance, or purchasing portions of syndicated loans or bonds at issuance. (For more, see FAQs: Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility.)
(3) A big drop in the bucket. A billion here, a billion there, adds up to $750 billion in financial support for the corporate sector. The Fed’s recently released Financial Accounts of the United States shows that during Q1, nonfinancial corporate bonds outstanding totaled a record $6.0 trillion and loans totaled $3.8 trillion (Fig. 5). Loans from depository institutions totaled $1.3 trillion, while “other loans” (including leveraged loans) totaled $1.9 trillion (Fig. 6).
(4) Zombies on life support. The Fed issued its first semi-annual Financial Stability Report during November 2018. The latest one was issued May 2020. All four reports recognized that there was too much dodgy corporate debt. Here is what the latest report had to say on the subject:
“At the beginning of 2020, about half of investment-grade debt outstanding was rated in the lowest category of the investment-grade range (triple-B)—near an all-time high. The amount of debt downgraded from investment grade to speculative grade in 2019 was close to the historical average over the past five years. However, almost $125 billion of nonfinancial investment-grade corporate debt has been downgraded to speculative grade since late February, and expected defaults may rise if the economic outlook and corporate earnings are revised downward. Widespread downgrades of bonds to speculative-grade ratings could lead investors to accelerate the sale of downgraded bonds, possibly generating market dislocation and downward price pressures in a segment of the corporate bond market known to exhibit relatively low liquidity.”
The report sounded the alarm on leveraged loans as well:
“Defaults on leveraged loans ticked up in February and March and are likely to continue to increase, with the specific contour highly dependent on the path of overall economic activity. Such developments would weaken the balance sheets of lenders, including CLOs that hold leveraged loans, and amplify the economic effects of COVID-19.”
During his October 30, 2019 press conference, Fed Chair Jerome Powell was asked about financial stability. He responded: “Obviously, plenty of households are not in great shape financially, but in the aggregate, the household sector’s in a very good place. That leaves businesses, which is where the issue has been. Leverage among corporations and other forms of business, private businesses, is historically high. We’ve been monitoring it carefully and taking appropriate steps.” He didn’t specify those steps. However, the Fed’s three interest-rate cuts during 2019 undoubtedly kept lots of zombies alive and fed their appetite for more debt.
As a result of the Great Virus Crisis, we now know how Powell is dealing with the corporate debt crisis. He is buying lots of it and enabling corporations to issue much more of it!