COVID-19 PANDEMIC + 2 MONTHS

It turns out we were quite prescient in our previous communications. Just as we expected, the US central bank, the Federal Reserve, enacted a number of measures to bring back liquidity into the capital markets. The US Congress and White House then took their turn with a massive fiscal policy move — 2.5 trillion dollars in spending. The end goal of both of these moves is to help the US economy get out of the downward spiral that the economy is currently undergoing. It is no longer a question of if the economy is in a recession (or quite likely a depression) but how long it will take to turn the economy around. In a fascinating twist, the Federal Reserve and US Treasury have so far taken on the major role of supporting the US economy. So, in this note we’ll take a look at the major structural problem that the US economy is facing currently and the moves the Federal Reserve and Treasury have taken so far, as well as the major new initiatives they are about to undertake, to help deal with this structural problem.

Before we get into the moves that the Federal Reserve and US Treasury are making, it should be noted that normally it’s fiscal policy (or spending by the US government) that gets the US out of recessions. And while the 2.5 trillion dollars in spending sounds like a huge amount (and it is, by historical standards), it is being substantially blunted by an enormous amount of spending reductions that are occurring at the state and local government levels. These are due to substantially reduced tax revenues that municipalities are experiencing as a result of the near stoppage of local economies. In fact, the additional spending on healthcare in the US in order to fight the new coronavirus will end up being larger than the net effect of the federal spending increases and municipal spending decreases. As a result, until further fiscal spending packages are passed that are substantially larger than the recent ones, the Federal Reserve and US Treasury will take on the major roles in stabilizing the economy.

In order to appreciate the monetary policy moves that have been made, we first need to understand the major structural problem the US economy is currently facing. The quarantine of 75% of the US population has resulted in a near shutdown of most of the economy. The effects start with businesses, who are seeing drastically reduced revenues. These businesses have bills to pay such as material costs, rent, wages, and property taxes. To see where the key stress points in the economy lie, let’s trace through each of these payment flows as examples.

Businesses purchase all kinds of things from other businesses: raw materials, equipment, services, etc. These are typically paid by drawing on short-term bank credit lines (or commercial paper if it’s a large business), which are then paid off by generating revenues. However, when revenues suddenly disappear, these businesses not only have difficulty paying their existing credit lines but they also need longer-term loans to keep financing their net working capital, such as inventories and unpaid bills, until revenues come back. So, all of their short-term borrowings suddenly become much riskier to lenders because it isn’t clear when revenues will come back and if the businesses will survive (not go bankrupt) long enough to see the return of revenues. As these loans become riskier, the liabilities of the lenders themselves (loans that banks take from other banks, for example) also become riskier because if the lender has made a lot of these commercial loans, it’s possible the lender may not survive if several of these corporate customers do not survive. And in turn, the lenders to the lenders also suddenly become riskier, and on and on.

Businesses have all types of fixed obligations such as rent, equipment loan/lease payments, insurance, etc. As revenues suddenly disappear businesses have a difficult time making these payments. Consequently, the owners of buildings, equipment, and other fixed assets in turn get into trouble on their payments. That is because most fixed assets are purchased via credit, such as commercial mortgages, equipment loans, etc. So, the owners of these assets suddenly run into difficulty making payments on the debt that is financing these fixed assets. This in turn puts the lenders into trouble because they too are borrowing in order to provide the financing to the asset owners for these fixed assets. And then the lenders to these lenders get into trouble, and so on.

In addition to fixed assets, businesses use labor, and they have to pay wages. As revenues dry up, businesses pare back on wage payments through furloughs, layoffs, and wage reductions. Of course, as the individuals who work at these firms lose wages, they can’t make good on the payments they owe. The payments that they miss are things like mortgage payments, auto loan payments, student loan payments, etc. As individuals miss these payments, then the lenders who made these loans find themselves with not enough revenue to make their payments. The payments they owe are on the loans they received to provide financing to the workers for homes, cars, etc. And then the lenders to these lenders get into trouble, and on and on.

These are just a few examples of how the crisis is transmitted and reverberates through the economy. What you see from all of these examples is that credit is the lifeblood of the global economy — it connects all individuals, corporations, and organizations — and the free flow of credit is critical for normal economic function. The market for credit is several hundred trillion dollars worldwide (well over ten times larger than the public and private equity markets combined). As a result, any economic crisis gets transmitted to the credit markets first. Then, as these credit markets freeze up, the global economy grinds to a halt as individuals and businesses can’t get the credit they need to function normally. This in turn causes a further lockup in the credit markets, which causes the economy to stall even further. And on and on. This is also commonly known as a liquidity crisis.

So, the Federal Reserve has been working to restore liquidity in markets by shoring up all of the various credit markets. The Fed has started buying long-maturity US Treasuries in order to hold down the cost of credit. They have started an unlimited amount of buying of all types of credit instruments, from asset-backed securities (auto loans, credit card receivables, student loans, equipment loans, etc.) and mortgage-backed securities to commercial paper, municipal bonds, and long-term corporate bonds including bond ETFs. They have stepped up by lending hundreds of billions of dollars to banks on a collateralized basis (overnight Fed funds), and they have also extended zero-interest loans to banks on an uncollateralized basis (lending through their discount window). They have even started extending dollar-denominated to the other central banks in the world in the hopes of dissuading them from selling their US Treasury bonds (which would lead to a higher cost of credit in the US) as they try to defend their currencies from depreciation against the dollar. The Fed hopes that the banks will put all of this cash to use in turn by making additional credit available to their customers. Essentially, the Fed is flooding the markets from all angles with credit in the hopes of unfreezing/supporting the credit markets. They have even taken a step never before done in Fed history: they have begun lending directly to companies — an unprecedented move whose repercussions will only be known in time. The Fed has also relaxed several bank capital rules, allowing banks to take more credit risk and thus extend credit to riskier borrowers than they might otherwise.

The Treasury too has stepped in by greatly expanding programs to lend directly to small businesses as well as back-stopping (providing a default guarantee) some of the purchases that the Federal Reserve is making, including their novel direct-lending program to corporations. The purpose of these moves, especially the direct lending to companies, is to lessen the perceived risk of credit in the US economy.

However, it’s important to recognize that these are all stabilization moves. They are being made in the hopes of preventing chains of bankruptcies and a complete freeze-up of the national and international credit markets. But, they will not by themselves get the economy going again, i.e., they will not start revenue generation for businesses. The only way revenue generation starts up again is with consumers and governments spending to purchase products and services. And this requires a combination of aggressive fiscal policy (heavy US government spending — much larger than what has been passed so far) and consumer confidence in a steady stream of wages from jobs again.