US equity indices were down about 3% mid-afternoon, despite an unprecedented commitment by the Federal Reserve to buy unlimited quantities of virtually all categories of debt securities as well as corporate-bond ETF’s. The Fed’s measure failed to impress markets after Senate Republicans and Democrats failed for a second day in efforts to pass an equally unprecedented $2 trillion bailout bill.
The Fed’s new intervention is less an intravenous tube than a fire hose. But it has not yet succeeded in stabilizing markets for high-quality securities that form the bedrock of the financial system. High-quality commercial paper with a AA rating, the short-term obligations of major corporations, usually yields a few hundreds of a percent more than Treasury bills.
Today the spread between AA commercial and Treasury bills shot up to 2.12%, approaching the 2.7% level touched during the 2008 financial crisis. Even large corporations may lose access to the short-term public borrowing market. The blowout in commercial paper spreads occurred after the Fed announced a special facility to buy commercial paper for its own account, in effect lending directly to corporations.
That is why St. Louis Federal Reserve President James Bullard warns that the unemployment rate might reach 30% during the second quarter and that economic activity might fall by half.
The Federal Reserve last week said it would buy $500 billion of US Treasuries and $200 billion of mortgage-backed securities. Today it removed the ceiling on prospective purchases, and added corporate bonds, municipal bonds, and commercial real estate mortgages to its shopping list. The spread between Treasuries and mortgage-backed and corporate bonds came in slightly, but still remains a multiple of normal levels.
Meanwhile, Senate Republicans and Democrats bickered openly on the floor of the Congress, and the Senate failed to reach an agreement on the $2 trillion emergency spending bill proposed by the Administration. At 1 p.m., just before news broke that the Senate remained at an impasse, the Dow Jones Industrial Average had recouped almost all of an early 5% loss. It plunged again after the Senate negotiations failed.
Republicans have a list of proposed subsidies for corporations that the Democrats don’t like, and the Democrats want an guarantee that corporations who receive aid won’t fire any workers. If the Senate doesn’t act quickly, the Democrat position will become moot as half of American workers lose their jobs. According to thehill.com, the Republican bill raises a “corporate bailout fund” to $500 billion.
A large share of the credit universe is in real distress, including high-yield debt issued by shale drillers now driven out of business by a $21 oil price, and real estate companies who own empty hotels and deserted shopping malls. The collapse of financing for high-quality, liquid debt is a bigger threat, however.
One of the sources of the avalanche of force sales is the $12 trillion overhang of foreign bank obligations to US banks, as I wrote in this space on March 13. During the past 30 years, foreigners have financed the cumulative US current account deficit by purchasing dollar-denominated US securities, and foreign banks have borrowed dollars in order to create hedges against dollar fluctuation for these investors.
The credit crunch in the United States has cut off interbank credit to foreign banks, who have to unwind the foreign exchange hedges. That, in turn, forces bank customers to sell securities. The $12 trillion size of these obligations is large enough to swamp the amount of money that the Federal Reserve is prepared to spend.
That is why direct spending by governments is so critical. Central banks, in theory, can print as much money as they like, but even the Federal Reserve can’t triple its balance sheet overnight without putting its own credit at risk. Markets have to expect a backstop for corporations before the run on credit comes to an end.