An overnight rally in world equities collapsed as bank liquidity deteriorated to levels not seen since the 2008 financial crisis. US equities opened slightly higher, driven by defense stocks, but the modest rally in US equities had faded into modest losses by 10 am.
Equity futures tracked the most sensitive gauge of bank liquidity, the cross-currency basis swap (the premium that banks pay to swap dollar cash flows in Euros). US banks have lent a cumulative $12 trillion or more to European and Japanese banks to provide currency hedges for dollar-denominated US securities. Faced with a run on cash by their customers and the prospect of a spike in loan defaults due to the seize-up of economic activity across the world, US banks are cutting back on credit to their foreign counterparts. The result is an extreme scarcity of dollar credit.
The euro-US dollar basis swap blew out to -120 basis points, the worst level since 2008, when it briefly touched -300 basis points. On Sunday the Federal Reserve announced swap lines to provide dollars to foreign central banks to be lent to foreign private banks, with limited impact. With $12 trillion of outstanding liabilities to roll over, most of them with a maturity of three months or less, nothing les than a trillion or two dollars in swap lines would solve the problem.
Credit pressures on European banks. Deutsche Bank, a bellwether for bank problems in recent years, saw the cost of default insurance on its subordinated debt jump to the highest level in history. Its senior debt has also deteriorated, although not nearly as far.
The huge spread between the cost of protecting Deutsche Bank senior and subordinated debt shows that investors fear that the bank regulators might sanction a reorganization that wipes out the subordinated bondholders, for example holders of preferred stock, while protecting the bank’s senior debt, including obligations to other banks. The 6% coupon perpetual preferred stock of Deutsche Bank – a bond with no claim on recovery in the event of bankruptcy – has fallen from a price of EUR 101 on February 21 to only EUR 63.2 this morning.
A vicious cycle is underway in which the liquidity crisis undermines the credit standing of European and Japanese banks, causing American banks to withdraw more dollar liquidity.
The worst performers in the S&P 500 Tuesday morning were companies hit directly by limited travel and hospitality: Boeing, Raytheon, United Technologies, McDonald’s and Starbuck’s. With hotel occupancy rates in many US cities at single digits, investors in hotel properties will begin defaulting on their mortgages by May. Fast-food restaurants, long considered highly conservative investments, have suddenly turned into cash sinks rather than cash cows. Some defensive stocks, though, jumped, including utilities and consumer staples companies. These were the US sectors I recommended in my May 14 column. Retail Real Estate Investment Trusts continued to fall; the largest traded retail REIT, Simon Property Group, lost another 5% to trade at just one-third of its year-ago price.
A tell-tale gauge of market liquidity is the interest rate differential between AA-rated corporate commercial paper (unsecured 3-month obligations) and ultra-safe US Treasury bills. This blew out to 2.3% from next to nothing a couple of weeks ago. It is still well below the 6% differential registered after the Lehman Brothers bankruptcy in September 2008, when investors withdrew their money en masses from money market funds.
The Federal Reserve is discussing a special bailout facility for commercial paper, in addition to a special bailout facility for municipal bonds, on top of the just-announced $1 trillion dollars in temporary support for the Treasury repurchase financing market, $500 billion in permanent purchases of US Treasury securities, and an unspecified volume of dollar swap lines to foreign central banks.
A trillion dollars here and a trillion dollars there begins to add up to real money. The $12 trillion that foreign banks owe to US banks on the short-term money market corresponds to the $11 trillion in cumulative current account deficits that the United States has racked up since 1990. Americans import more than they export, because they want to consume rather than save – and because the rest of the world has been eager to lend them the money to do so. The aging populations of Europe and Japan want to save for retirement, and to earn the money to do so, they export more than they import and save the proceeds.
That has snapped, and the problem is so large that the Fed and other central banks can only relieve the pressure temporarily. The long-term solution for the problem requires the United States to save more and import less – but in the short term, that implies a drop in consumption and a recession. The financial markets, responding to the global health emergency, are forcing an adjustment that is long since overdue.
In the short-term, the federal government will mitigate the pressures from the financial markets by bailing out illiquid markets, buying commercial paper or municipal bonds, increasing unemployment insurance payments, cutting taxes, or whatever it takes to put money into the pockets of Americans whose livelihood is threatened by the health crisis. Even the US government can only do so much. It is extraordinary for the federal government to run a $1 trillion deficit at a time of full employment, and the emergency measures now in the planning stage will probably double this deficit. If the United States does not make an adjustment to a higher savings rate and a lower current account deficit, eventually financial markets will penalize the debt of the federal government itself, and force such an adjustment upon the US.