The New York Fed announced Thursday afternoon that it would inject a record $1 trillion into US money markets by purchasing Treasury securities across a range of maturities. That is quantitative easing on a scale and with a speed never seen before. The Fed is trying to stop a financial avalanche that threatens to bury risk assets and throw the world into a deep recession.
US stock prices, which had fallen by almost 10% at the lows of the Thursday session, recovered a good deal of their lost ground.
Former Atlanta Federal Reserve President Dennis Lockhart was quoted by news services Thursday predicting that the Fed would offer emergency liquidity injections, including additional credit facilitiesin dollars for foreign central banks.
As the Bank for International Settlements warned in its September 2017 Quarterly Report: “The combination of balance sheet vulnerabilities and market tightening could trigger funding problems in the event of market strains. Market turbulence may make it more difficult for banks to manage currency gaps in volatile swap markets, possibly rendering some banks unable to roll over short-term dollar funding. Banks could then act as an amplifier of market strains if funding pressures were to compel banks to sell assets in a turbulent market to pay their liabilities that are due. Funding pressure could also induce banks to shrink dollar lending to non-US borrowers, thus reducing credit availability. Ultimately, there is a risk that banks could default on their dollar obligations.”
That prescient warning encapsulates what we saw on global markets Thursday morning, and explains the Federal Reserve’s extraordinary intervention.
Some of the safest financial assets are crashing as the short-term health crisis unearths deep flaws in the world financial system. The biggest imbalance in the world economy is the cumulative cost of financing the US current deficit during the past 20 years, supported by tens of trillions of dollars of foreign exchange derivatives required to hedge international investments. Now that banks are compelled to reduce balance sheets, a global cash crunch is forcing Asian and European investors to liquidate dollar-denominated assets.
I warned about this danger in an Oct. 18, 2018 feature for Asia Times entitled, “Has the derivatives volcano already begun to erupt?” The Federal Reserve aggressively eased monetary policy at the beginning of 2019, forestalling the crisis which is now upon us.
European bank stock prices are in free fall, with the European bank stock index down by nearly half since late February.
The cost of credit protection for European financial companies’ subordinated debt has more than tripled since February 28, from 100 basis points above LIBOR to 323 basis points at noon on March 12.
Emergency action by central banks can prevent extreme disruptions to the banking system, but the world faces the mother of all credit squeezes.
Meanwhile the collapse of US real (inflation-indexed) government bond yields due to risk-aversion has left US yields below the level of Japanese yields for the first time in history. Japanese investors have no reason to buy US government debt.
European and Japanese banks meanwhile are squeezed for funds. During the past 20 years they have provided foreign exchange hedges for their customers, who financed the US current account deficit mainly by purchasing US securities. That is, the European and Japanese banks borrowed dollars from American banks and sold them on behalf of their customers. In the process, they accumulated $13 to $14 trillion of net liabilities to US banks. As their credit deteriorates, and as US banks face sudden demands on their own balance sheet, they are being shut out of the interbank lending market. A measure of credit rationing to Japanese banks is the so-called cross-currency basis swap, the additional cost of swapping cash flows from dollars into yen. Until the last couple of weeks, banks charged 10 to 20 basis points for such swaps. Now the cost of swapping cash flows is nearly 90 basis points.
European and Japanese banks find themselves unable to roll over their foreign exchange assets, so they are selling whatever they can, for example, high-quality US mortgage-backed securities. In this sort of squeeze, fund managers sell not what they want to sell, but what they are able to sell.
Mortgage-backed securities with government backing are safe and liquid assets, and the blowout in their yield differential with Treasuries is an indication of forced sales.
Meanwhile, the European Central Bank announced that it would expand its buying of corporate bonds and offer easier liquidity conditions for European banks on loans from the central institution.
The central banks can forestall a financial disaster, but they cannot stop the deleveraging of balance sheets that already has cut off credit to important sectors of the world economy.