The COVID-19 crisis has accelerated many structural trends that were evident previously – e-commerce, the cashless society, remote working – just to name a few.
In financial circles, the trend that has been super-charged post-COVID is the trend toward “administered markets”. Governments are relaxing bankruptcy laws; central banks are relaxing access to funding; and banks are being directed on what to buy, who to lend to and how to use their free cashflow. Administrators around the world are now more deeply embedded and more intrinsically involved in the determination of market risk than ever before.
In our view this is not a trend that will abate anytime soon. Investors therefore need to adapt.
The intervention of governments and central banks in financial markets is not new. The Bank of England (BOE) and Bank of Japan (BOJ) have a long history of being involved in salvaging firms after economic downturns. Central bank involvement in currency management is also common though is mostly a tool used by emerging markets.
The BOJ was the first major central bank to undertake quantitative easing (QE) in March 2001. Quantitative easing involves unusually large purchases of assets by a central bank financed by money creation. Most of the assets purchased by the BOJ consisted of Japanese government bonds. This was later extended to include equities via exchange traded funds (ETFs). The BOJ now holds assets on its balance sheet worth almost 700 trillion yen, equivalent to 128% of its GDP (chart 1).
Chart 1:Bank of Japan balance sheet (trillion yen)
The level of central bank intervention took a step up after the Global Financial Crisis (GFC). Since that time, policymakers have been deliberately suppressing volatility, compressing risk premia, tamping down credit spreads and keeping the market wide-open for borrowers for the better part of two decades.
To QE-infinity and beyond
On the 24th March, in response to the COVID-19 crisis, the US Federal Reserve (the Fed) took quantitative easing to a whole new level. The Fed announced “QE infinity” – unlimited buying of government and mortgage-backed bonds. In addition, it announced it would purchase corporate bonds which later extended beyond investment grade to include high yield corporate bonds.
This move went well beyond even the QE announced after the GFC. At its peak during the COVID crisis, the Fed was buying $1.2 billion worth of bonds every hour. This compares with a purchase rate of $118 million per hour at the peak after the GFC (chart 2).
What was once a policy used only by the BOJ, in an attempt to stoke inflation, has now gone viral. Some 30 central banks around the world are now engaged in asset purchases of both government and private securities.
Chart 2: US Federal Reserve balance sheet (USD trillion)
If there is any doubt about this just consider the following:
– The Fed owns a third of all mortgage backed bonds in the US;
– The Fed now owns a total of 22,913 different financial securities;
– The Bank of Japan is the single largest owner of the Japanese equity market owning more than half of the country’s exchange trade funds (ETFs);
– The central banks in Japan and Europe each own almost half of all their respective government bonds outstanding (chart 3).
With unlimited capacity to print money, central banks have unlimited capacity to intervene in asset markets.
Chart 3: Share of ownership of all public bonds outstanding (%)
Distorted market pricing
Never before in its 106-year history has the US Federal Reserve played such a starring role in financial market price setting. While Chairman Powell is the third generation of QE-driven Fed Chairs, none of his predecessors took it to such a degree as he has.
Central bank asset purchase activity impairs price discovery. In this world, the price of an asset no longer represents the risk implied by its fundamentals. This applies to assets in both the bond and equity markets. A good example of this is the 896% rise in the Hertz share price in June after it was announced the US Federal Reserve was a buyer of its bonds. Hertz filed for bankruptcy in May. The Fed’s policy is causing risk to be misrepresented in the marketplace.
It is very difficult for an investor to measure risk responsibly and accurately when the Fed is buying bonds in such scale and where the sole intention is to drive interest rates down, irrespective of the underlying fundamentals of the securities it is buying. Not only did the Fed purchase Hertz shares, it was also a buyer of JC Penney and Nieman Marcus shares.
We have seen yields on corporate bonds come down significantly since the Fed began intervening because the additional risk premium earned for taking the risk of a defaulting borrower is no longer there (chart 4). If the borrower is protected from default, the lender should not receive any additional premium for buying default risk (because the risk no longer exists).
This is where the actions of the Federal Reserve affect investors. By interfering in the market, attempting to flatten the business cycle, pricing is distorted. The implication from this is that fundamentals, whilst still important, are relegated to the backseat. Central banks are not buying assets based on fundamentals. They are buying assets based on the need to supress interest rates in order to cushion an economic downturn.
It is not just the fixed income market that is being manipulated in this way. Interest rates in the US are arguably the most important interest rates in the world. It is against this interest rate that most other financial market instruments are priced – bonds and equities.
The market is driven more by the actions of central banks than the results of companies because the central bank has a bigger balance sheet than any company in the world. The term “don’t fight the Fed” is now part of the discussion of investment committees the world over.
Chart 4: Yield for US investment grade bonds (%)
Check-out anytime you like but you can never leave
When the Federal Reserve officially started its first quantitative easing program in 2009, an assurance was made that these would be “temporary measures” and that they would return back to normal when the financial conditions would allow it.
And so we wait, for more than a decade now.
The rationale for quantitative easing was two-fold. By lowering bond yields, it would encourage new investment which would drive economic growth. Second, it would drive a portfolio effect whereby investors, faced with such low interest rates, would be forced into allocating to riskier assets such as equities. The upward pressure this would put on riskier asset prices would create a wealth effect that would then lead to higher consumer spending.
In reality, the only real effect was to boost asset prices and encourage greater levels of corporate debt. Consumer spending didn’t lift to any great degree because not all consumers owned the assets whose prices were lifting.
Once the decision is made to go down the path of quantitative easing it is difficult to turn back. The Bank of Japan has been purchasing financial assets since 2001. Nearly twenty years on it is still purchasing financial assets, competing with other investors to do it.
There are at least two reasons why it is hard to wind back quantitative easing particularly when the zero bound of official interest rates has been hit.
First, the act of buying assets to keep interest rates down interferes with the natural order of the business cycle. Underperforming companies are artificially sustained. A healthy economy is one where business are allowed to go bust. This ensures efficient allocation of resources and so drives potential economic growth higher. So ironically, the longer quantitative easing is maintained, the slower, more lethargic, less dynamic economic growth becomes, the more quantitative easing is relied upon as a stimulant.
Second, the policy itself creates such a distortion in the market, an imbalance that is based on artificial support, that its cessation would be too destabilising. It is far easier to inject liquidity into the system than to remove it because the issues created by the injection are not as immediately deleterious as those created when the liquidity is withdrawn. A collapse in the asset prices that have been so significantly supported by quantitative easing would have far reaching consequences. Interestingly, the US Federal Reserve has itself become too big to fail.
Incredibly, official interest rates in at least eighteen countries around the world have now been cut to zero. This leaves quantitative easing and fiscal policy as the two key policy tools that remain. The next downturn is likely to arrive before central banks have a chance to lift interest rates back to more normal levels which means further fiscal policy expansion is likely. In order to keep servicing costs for the government down, the central bank will need to continue to undertake quantitative easing.
In our view, we arrive at just one conclusion: the US Federal Reserve will take the global financial system even further down the path of administered markets in the years to come.
Whether we like it or not, we are operating in an environment of “administered markets”. That is, central banks are influencing market movements to such an extent that price discovery based on fundamentals is very difficult. How should investors adapt to this new age?
First, in this new world, we are likely to see periods of relative financial market stability interrupted by market tantrums. As Nouriel Roubini says, it will be a world characterised by “macro liquidity and market illiquidity”. Risk premiums will continue to be compressed as investors crowd into overvalued markets. These crowded positions are then susceptible to event risk, potentially leading to rapid and violent position unwinds. Ensuring you have an effective airbag for your portfolio in the form of a liquidity bucket will help cushion any impact this may cause.
Second, beware of currency volatility. In the 80s bond vigilantes could force the hand of the Federal Reserve. In an age where central banks are bigger participants in the bond market than any investor, bond vigilantes will become currency vigilantes. If US investors feel government deficits are getting too large, rather than sell bonds, they will sell the currency.
Third, trying to time the market in this environment will become more difficult. Company fundamentals and earnings profiles can be modelled, central bank reaction functions can’t. Indeed, sometimes it is not the central bank reaction that moves the market but rather the central banks reaction to the markets’ reaction. This is what George Soros called “reflexive relationships”.