Category Archives: Credit markets

2020

It’s this time of the year. This post recalls events of 2020. It has been such an unusual year, so different from what we expected. Luckily, there seems to be light at the end of the very long and dark tunnel, and – I hope – that 2021 will be considerably more joyful than 2020.

2020 started out so well. The roaring twenties and all that. Wuhan was a city I had not heard of, corona a beer people tell me is best served ice-cold with a slice of lime (I do not drink beer, tough I do enjoy wine), and social distancing words we would only get to know too well. Today, we know that Wuhan is a Chinese city with more than eleven million inhabitants and a marketplace where it presumably all started, corona also means something terrible, and social interaction is an activity we have come to miss so dearly.

At the time of writing, app. 75 million cases of corona/COVID-19/SARS-CoV-2 have been confirmed globally and app. 1.7 million people have passed away because of corona. Most countries have been in lockdowns, many still are (again), and the social and economic costs of the crisis have been enormous.

I started this blog in April 2020. This had nothing to do with corona. I had wanted to set up a blog for some years (people ask me where I find time for this, and I really do not know, but seemingly I simply like writing economic stories and analyses). Starting the blog in April this year, however, naturally implied that many of the blog posts have dealt with various economic and financial aspects of the pandemic. In this post, I will review some of the learnings from 2020.

The worst recession on record. With the highest growth rate on record

The recession started in February 2020 in, e.g., the US. Initially, it was caused by a supply shock: lockdowns were imposed and firms could not sell their goods and services and households could not go shopping. In April, when the IMF released their Spring Outlook, they labelled it “The Great Lockdown”. This was a suitable label. The IMF also noted that “This is a crisis like no other” and that “many countries now face multiple crises—a health crisis, a financial crisis, and a collapse in commodity prices, which interact in complex ways”. As unemployment and bankruptcies increased, households and firm got nervous, and demand suffered, too.

The path of economic activity has been highly unusual. This graph shows the quarterly percentage changes in US real GDP since 1947:

Quarterly percentage changes in US real Gross Domestic Product. 2020 encircled.
Source: Fed St. Louis Database

2020 is very much an outlier. On average, from 1947 through 2020, real GDP has grown by 0.8% per quarter. Until 2020, quarterly growth had never exceeded 4%. Economic activity had never contracted by more than 2.6%. Then came the Great Lockdown. During the second quarter of this year, economic activity contracted by 9%. This is almost four times more than the otherwise worst contraction on record. In this sense, it was the worst recession ever.

It has also been the weirdest recession ever. During this recession, we have also witnessed the highest growth rate on record: economic activity expanded by 7.4% during Q3. This is twice as much as the otherwise highest growth rate on record.

This puzzling feature of the recession led me wondering what a recession really is (link). I expressed sympathy with members of the NBER Recession Dating Committee. They face a particularly difficult task this year. Should they conclude that we had one V in spring, with the recession ending in late April, and then a new V now, i.e. two separate Vs (VV), or that we have had one long recession with a double dip, i.e. a double-V (W)? Does it make sense to call it a recession when we experienced the fastest rate of growth in economic activity on record? If you conclude that the economy cannot be in recession when it expands at its fastest growth rate ever, then you must conclude that the recession ended during Q2. But, the NBER Recession Dating Committee has not called the end of the recession yet, i.e., officially, the recession is still ongoing.

You may ask why it is important to know whether the recession ended in April or whether it is still ongoing. The development in economic activity is what it is, whether we call it recession or not. It is important because a “recession” is such an important concept in economics. We inform the public, business leaders, students, and others about the characteristics and consequences of recessions. If a recession can contain the by-far strongest expansion of economic activity on record, we need to change our understanding of recessions.

The very unusual behavior of economic activity during Q2 and Q3 caused very unusual, and scary, developments in unemployment and related aspects of economic activity. This graph shows the monthly change in the number of unemployed in the US:

Monthly changes in the number of unemployed in the US. Millions. 2020 encircled.
Source: Fed St. Louis Database

During March, unemployment in the US increased by 16 million. Again, this was beyond comparison. Until March 2020, the number of unemployed had never increased by more than one million over one month. In March 2020, it increased by 16 million.

As the virus contracted during summer, unemployment fell. There has never been as fast a reduction in the number of unemployed as the one occurring during this summer. In May, the number of unemployed dropped by more than three million. Until May 2020, the number of unemployed had never fallen by more than one million over one month. In May 2020, it fell by more than 3 million. So, within a year, we have had the strongest-ever increase in unemployment, but also the largest-ever fall in unemployment. By far.

Such dramatic events happened all around the world. I documented this here (link) and here (link).

Inspired by these events, I did something admittedly nerdy. I calculated the probability that we would experience events such as these, given the historical data (link). I found the unconditional likelihood that we could see the increase in newly registered unemployed that we saw in spring to be 0.97 x 10^(-841). This is a zero followed by 841 zeroes and then 97. For all practical purposes, this is a zero-probability event. But it did happen. It was just very, very unusual.

The stock market

I use some of my time (a significant part, by the way) to try to understand the stock market. This has not been a straightforward task this year.

Today, the global stock market is 13% percent above its January 1 value, the US stock market is 18% higher, and the Danish stock market 29% higher (MSCI country indices). Given that we have been through the worst recession ever, and that the recession is not officially over yet, this is not what one would have expected prior to the events.

Then, on the other hand, in hindsight it is perhaps not so strange. The recession has been the worst on record, yes. But, we have also had the fastest growth in economic activity on record. I argued (link) that if we imagine that the recession ended in late April, when economic activity bottomed out, the behavior of the stock market fits perfectly well with the historical evidence on the behavior of the stock market.

Central banks have certainly played their role, too. When markets melted down in March, central banks intervened heavily. In contrast to the financial crisis of 2008, it was not banks that were in trouble this time, but firms. Firms could not sell their goods and services due to the lockdown. The limitless purchases of government bonds that central banks have become used to during and after crises thus probably did not do much good (evidence came out that central bank purchases of government bonds are less effective than we are often told, link ). What turned things around, instead, was the announcement on March 23 that the Fed would facilitate credit to firms (link). This was a new policy tool. It led to a complete turnaround of events. I produced this graph (I still think it is a supercool graph): 

Difference between yields on ICE BofA AAA US Corporate Index and 3-month Treasuries (Left hand axis) as well as the SP500 inverted (Right hand axis). Both series normalized to one on January 2, 2020. Vertical line indicates March 23.
Source: Fed St. Louis Database

The graph shows how the stock market lined up with credit spreads. Firms were suffering, and their credit spreads started widening, in late February. The stock market suffered. The Fed announced it would provide credit to firms on March 23. Credit spreads tightened. The stock market cheered. The graph summarizes how the Fed saved credit and equity markets. And, strikingly, the Fed did so by merely announcing they would intervene. Up until today, the Fed has not intervened a lot. In this sense, it was a “Whatever it takes moment of the Fed”.

It should be mentioned that the Fed announced other initiatives on March 23, too, such as the Main Street Lending Program (link) and the Term Asset-Backed Securities Loan Facility (link). The Corporate Credit Facilities were the ones that directly targeted corporate bonds, though. Due to the nature of this crisis, the stock market lined up with credit spreads during this crisis, as the above graph reveals, emphasizing the importance of the announcement of the Corporate Credit Facilities.

Eurozone troubles, or rather no Eurozone troubles

The fact that we have not had to talk a lot about the risk of a Eurozone breakup since summer has been a positive surprise. In spring, there was talk about the risk of a Eurozone crisis. Like so often before, Italian sovereign yields rose relative to German sovereign yields. There was reason to be anxious. I argued that “Some kind of political solution at the EU level would be needed” (link).

This we got. The European Union agreed on a “Recovery and Resilience Facility” (link) that includes both loans and grants. EU has moved one inch closer towards a common fiscal policy. Who will pay is not clear, but EU has shown solidarity. I believe this is positive. At the same time, the European Central Bank continued its interventions and bought a lot of Italian debt. This has kept yields on sovereign bonds low. Here is the Italian-German yield spread during 2020:

Italian yield spread towards Germany. Ten-year government bonds. Daily data: January 2, 2020 – December 21, 2020.
Data source: Thomson Reuter Datastream via Eikon.

Italian yields have been falling continuously since summer, when the EU agreed on its recovery plan. It is positive that we have not had to discuss Eurozone troubles. We have had so many other troubles. Whether this means that we do not have to discuss Eurozone troubles again at some point, I am less sure. But, that is for another day.

Banks have been doing OK

The risk of a Eurozone breakup did not materialize. Another risk that did not materialize was the risk of systemic bank failures. This is positive as well, as economic activity suffers so much more when banks run into trouble and credit consequently does not flow to its productive uses.

During the worst days in March, stress in the banking system intensified. For instance, the spread on unsecure interbank lending increased relative to secure lending:

The TED spread. Difference between 3-Month USD LIBOR and 3-Month US Treasury Bills. Daily data: January 2, 2000 – December 14, 2020. 2020 encircled.
Data source: Fed St. Louis Database.

Stresses lasted only a few days, though. During the financial crisis in 2008, on the other hand, spreads remained elevated for much longer. This time, trust in the banking system was quickly reestablished.

I think I am allowed to claim that this was one of the predictions I got reasonably right. In autumn 2019, when nobody knew about the upcoming crisis, I wrote a policy paper on the Nordic financial sector. It was presented in December 2019 and finally published in June this year (link). I argued that banks are safer today, compared to 2008. Some doubted my conclusion and said, “just wait until the next crisis, then you will see that banks are not safer today”. Well, few months later we had the worst recession ever. Luckily, though, we have not had bank-rescue packages and we have not had to bail out banks. Banks have been withering the storm. In some instances, banks have even been part of the solution by showing flexibility towards troubled firms. I am not saying everything is perfect, but I am saying that the situation has been very different from the situation in 2008. On a personal note, this made me happy, too, as it would have been somewhat embarrassing if banks had failed at the same time I published an analysis arguing that the banking sector is safer. This, luckily, did not happen. Instead, the banking system turned out to be far more resilient than in 2008, as I predicted.

You may add that the Fed rescued markets during spring, as mentioned above, and thereby rescued firms and subsequently banks. True, but there was certainly also tons of rescue packages in autumn 2008. Banks nevertheless failed in large numbers in 2008. They did not this time around. Perhaps, thus, we did learn something from the financial crisis of 2008, and have gotten some things right. This would be no small achievement.

US election and Brexit

There have been other events, for instance the US election and Brexit negotiations. In normal years, such events would potentially have been among the most important events for markets and the economy. This year, the pandemic has certainly been more important. I did manage to write a post on the US election and the stock market, though (link). I discussed evidence that stock markets perform better under Democratic presidents. Only time will tell whether the same will happen under Biden.  

I did not manage to find space to discuss Brexit, but we got a trade agreement on Dec. 24 (link). Hopefully, the EU and UK can now move on.

The cost of the crisis

It is impossible to summarize the pandemic in one number or one word. Hence, I will not attempt to do so. But, I did present a calculation of the expected cost of the crisis in Denmark (link). I arrived at DKK 336bn, or app. USD 10,000 per Dane. This calculation generated some attention in Denmark.

One can discuss every single assumption one needs to make when calculating the expected cost of a crisis: What is the value of a statistical life? What is the value of a statistical life of those who pass away due to COVID-19, i.e. who are typically above 80? What is the past loss as well as the expected future loss in economic activity due to the crisis? Does it make sense to present one number when there is so much uncertainty? And so on. These are all fair points, but if we want to have a meaningful discussion of the impact of the crisis, we have to start somewhere.

In my calculation, I closely followed the assumptions of Cutler & Summers, such that US numbers and Danish numbers can be compared. This allowed me, for instance, to conclude that the cost of the crisis in Denmark, most likely, will be much lower than the cost of the crisis in the US.

Conclusion

I must admit I find it difficult to end this last post of 2020 on a happy note. Right now, at the time of writing, the situation is bad in the country I live, Denmark, and in many other countries in Europe and around the world. Numbers of new cases and deaths have been rising recently, or are on the rise again, and more and more restrictions and lockdowns are being imposed. Days are grey and short. The crisis has already been tremendously costly and it is clearly not over yet.

Nevertheless, I will try to end the post on a positive note. It gives me hope that several countries have started vaccinating people, and it seems to be working well. Finally, the EU also starts vaccinating people now. This has taken way too long, however, given the severity of the crisis and the fact that other countries started weeks ago. And, yes, every day counts. If it is correct, though, and I deliberately write if, that the EU has failed when it comes to the approval process and purchase of vaccines, as the normally well-informed and serious magazine Der Spiegel claims (link), it is a scandal. Biden aims to vaccinate 100m Americans within his first 100 days in office (link), close to a third of the US population. As things look now, it seems unlikely that we will be able to achieve the same in Europe. Christmas is all around us, though, so let us hope that somehow things will develop in the right direction.

Therefore, let me focus on the bright side. With the jabs, the situation will most likely start to improve within a not too distant future. I will try to convince myself that I see weak light at the end of the long and dark tunnel, even when we probably have to wait many months before things really calm down. Days are at least getting longer. I will focus on this, then.

With this, which is meant to be a positive message, let me thank you all for reading this blog and for sending me many encouraging mails with feedback. Please keep on doing so – it is highly appreciated.

I conclude by expressing hope that next year will be considerably more joyful than the one we leave behind.

Happy New Year!

The Fed’s “Whatever it takes” moment. Or, how the Fed saved equity and credit markets

Facing a looming recession and financial market panics, the Fed intervened heavily in late-February/early-March, lowering the Fed Funds Rate to zero and expanding its balance sheet dramatically. In spite of this, markets kept on panicking. Then, suddenly, on March 23, everything changed. Stock markets started their rally. This was not because the Fed lowered the rate or expanded its asset purchases even further, nor because the economic data improved. What happened? The Fed made an announcement. Nothing else. It is a fascinating illustration of how expectations can change everything on financial markets.  

Much has been written about the massive interventions of the Fed during February and early March. In my previous post (link), I list Fed interventions as one of the reasons why the stock market is back to pre-crisis highs. In this post, I dig one step deeper and explain the fascinating story of how the Fed said something and thereby rescued markets.

Asset purchases and rate reductions did not save markets in February/March

Let us start by illustrating how the actual Fed interventions (interest rate changes and asset purchases) did not save markets in March. The Fed lowered the (lower range of the) Fed Funds Target Range to 1% from 1.5% on March 2 and then again to 0% less than two weeks later, on March 14. At the same time, it bought Treasuries and mortgage-backed securities to the tune of USD 600bn per week. These interventions succeeded in lowering yields on government and mortgage-backed bonds, but did not cheer up stock markets.

This graph shows how Treasury yields came down significantly in February/March, by basically 1.5%-point (from close to 2% to close to 0.5%; I show yields on 10-year Treasuries in this graph), as a result of reductions in the policy rate (the Fed Funds Rate) and asset purchases by the Fed.

SP500 and yield on 10-year Treasuries. Daily data.
Source: Fed St. Louis Database

The graph also shows that the SP500 continued falling throughout February/March. In other words, the massive interventions by the Fed in late-February/early-March (and these interventions really were massive – buying for USD 600 bn per week and lowering rates to zero is indeed a massive intervention) did not convince stock markets that the situation was under control. And, remember, these were not minor stock-market adjustments. It was the fastest bear market ever (link).

What turned the tide?

On March 23, the SP500 reached its low of 2237, a drop of 31% compared to its January 1 value. Since then, everything has been turned upside down and markets have been cheering, as the above graph makes clear.

What happened on March 23? The Fed had its finest hour. It did not do anything. It merely said something. A true “Whatever it takes” moment.

As you remember, a “Whatever it takes” moment refers to the July 26, 2012 speech by then ECB-president Mario Draghi (link). The speech was given at the peak of the Eurozone debt crisis. The debt crisis pushed yields on Italian and Spanish sovereign bonds to unsustainable levels. Italy was too big to fail, but also too big to save. The pressure on Italy was a pressure on the Eurozone construction. Mario Draghi explained the situation and said the by-now famous words:

But there is another message I want to tell you. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

Investors understood that the ECB would be ready to buy sovereign bonds to save the Euro. Markets calmed down. Italian and Spanish yields fell. And this – and this is the point here – without the ECB actually intervening, i.e. without the ECB buying Italian or Spanish bonds. The announcement that the ECB would intervene was enough to calm down investors.

Why is this relevant here? Because on March 23 the Fed sent out a press release, announcing that:

“…the Federal Reserve is using its full range of authorities to provide powerful support for the flow of credit to American families and businesses.”

And, then, as one of the new features announced the:

Establishment of two facilities to support credit to large employers – the Primary Market Corporate Credit  Facility (PMCCF) for new bond and loan issuance and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds.

This statement turned everything upside down. The important thing is that this turn of events happened without the Fed using any money at all. It was a “Whatever it takes” moment (though, perhaps not as Dirty-Harry dramatic as Mario Draghi’s “And believe me, it will be enough”): The Fed announced what they would do, investors believed the Fed, and markets started cheering. It is a prime example of how investor expectations influence financial markets.

What are the PMCCF and SMCCFs, why did the Fed announce them, and why were their effects so dramatic?

The lowering of the Fed Funds Rate and the purchasing of Treasuries succeeded in lowering yields on safe assets, such as Treasury bonds, as explained above, but did not lower yields on corporate bonds. In fact, during the turmoil in late-February/early-March, credit spreads (the spread between yields on corporate bonds and safe bonds) widened dramatically. When yields on corporate bonds rise, it becomes more expensive for corporations to finance their operations. And, when yields rise a lot, as in February/March, investors get nervous about the profitability and survival of firms.

This graphs shows how yields on both the least risky corporate bonds (Triple A) and speculative grade bonds (Single B) rose dramatically in relation to 3-month Treasury Bills, with yields on lower-rated bonds (Single-B) naturally rising more than yields on higher-rated (Triple-A) bonds.

Difference between yields on ICE BofA AAA US Corporate Index and 3-month Treasuries as well as the difference between yields on ICE BofA Single-B US High Yield Index and 3-month Treasuries. Daily data.
Source: Fed St. Louis Database

The important point in the picture is that the spreads continued rising throughout late-February/March, in spite of the intensive interventions described above, i.e. in spite of Fed purchases of government and mortgage bonds. The Fed was happy that safe yields fell, but was concerned that credit spreads kept on rising. Volatility in corporate bonds markets also rose (link), making the whole thing even worse.

More or less all firms saw their funding costs increase, even when there were differences across firms in different industries, with firms in the Mining, Oil, and Gas, Arts and Entertainment, and Hotel and Restaurant sector hit the hardest, and firms in Retail and Utilities sectors less affected (link). The Fed became nervous because higher funding costs for firms affect firms negatively, causing them to cut jobs, reduce investments, etc.

The Fed decided to act. It announced on March 23 that it would launch two new programs, PMCCF and SMCCFs. The PMCCF is the ’Primary Market Corporate Credit Facility and the SMCCF the Secondary Market Corporate Credit Facility. Primary markets are where firms initially sell their newly issued bonds. The PMCCF should thus ease the issuance of newly issued corporate bonds, i.e. help firms raise funds. Secondary markets are where bonds are traded afterwards, i.e. the SMCCF should ease the trading (liquidity) of already existing corporate bonds.

The effect on equity and credit markets of the announcement of the PMCCF and SMCCFs was immediate and spectacular. Immediately after the announcement, credit spreads narrowed (see, e.g., link, link, and link).

Interestingly, stock markets reacted immediately, too. The stock market, thus, did not react to the lowering of the Fed Funds Rate and the extensive expansion of the Fed balance sheet in late-February/early-March, but reacted strongly to the announcement that the Fed would buy corporate bonds on March 23.

This (supercool, I think 🙂 ) graph shows developments on corporate bond and equity markets. The graph shows the spread between yields on AAA-rated corporate bonds and 3-month Treasury Bills and the stock market inverted, both normalized to one on January 1. The graph for the inverted stock market means that when the SP500 is at 1.45 on the y-axis on March 23, the stock price at January 1 was 45% higher than it was on March 23.

Difference between yields on ICE BofA AAA US Corporate Index and 3-month Treasuries (Left hand axis) as well as the SP500 inverted (Right hand axis). Both series normalized to one on January 2, 2020. Vertical line indicates March 23.
Source: Fed St. Louis Database

The parallel movements in equity and credit markets are striking. Equity and credit markets moved in parallel during January, when stock markets rose and credit spreads narrowed, in late-February/early-March when credit spreads widened dramatically and stock markets fell like a stone, as well as after March 23, when both credit spreads and stock markets improved spectacularly. Since then, stock markets have continued to rise and credit spreads have continued to narrow.

The correlation between the two series is an astonishing 0.93 for the January 2 through May 31 period.

The announcement effect

The Fed has experience with and a mandate to buy mortgage-backed securities and Treasuries. It had no such experience when it comes to purchases of corporate bonds and corporate bond ETFs. This means that the Fed could not start buying corporate bonds on March 23, it needed an institutional set-up. It created an SPV with capital injections from the Treasury and leverage from the New York Fed, it asked a financial firm (Blackrock) to help them purchase the bonds, etc. These things take time. The Fed only started buying corporate bond ETFs in mid-May and corporate bonds in mid-June.

Given that the Fed only started buying bonds and ETFs in May/June, the spectacular turnaround on March 23 really was due to the announcement only.

In slightly more detail, it played out as follows. The March 23 announcement primarily dealt with higher-rated corporate bonds (Investment Grade), and spreads narrowed immediately. On April 9, the Fed announced that they would expand “the size and scope of the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF)”, buying bonds that were Investment Grade on March 22 but had been downgraded since then as well as corporate bond ETF. High-yield spreads tightened even more (link). Today, the Fed explains that the programs allow the Fed to buy “investment grade U.S. companies or certain U.S. companies that were investment grade as of March 22, 2020, and remain rated at least BB-/Ba3 rated at the time of purchase, as well as U.S.-listed exchange-traded funds whose investment objective is to provide broad exposure to the market for U.S. corporate bonds.”

The actual purchases began in May/June, several months after the announcement. Interestingly, the purchases themselves have had a modest impact only. First, the amounts of corporate bonds and corporate bond ETFs bought pale in comparison with the amounts of mortgage-backed securities (MBS) and Treasuries bought. The Fed has bought MBS and Treasuries to the tune of USD 3,000bn this year. It has “only” bought corporate bonds and ETFs for around USD 12bn. The amount used to buy corporate bonds thus corresponds to less than 0.5% of the amount used to buy MBS and Treasuries. This graphs shows the daily purchases. Using the latest figures from August 10, the Fed has basically stopped buying corporates.

Daily Fed purchases of corporate bonds and corporate bond ETFs. Daily data.
Source: Fed webpage. Thanks to Fabrice Tourre for collecting and sharing the data.

So, the Fed has not bought a lot of corporate debt. It has, however, the power to buy a lot. The PMCCF and SMCCF set-up is such that the Treasury has committed to make an USD 75bn investment in the SPV that buys the assets (USD 50bn toward the PMCCF and USD 25bn toward the SMCCF). The New York Fed then has the ability to level this up by a factor of ten, i.e. the Fed can buy corporate debt for up to USD 750bn. This is a sizeable fraction of the total US corporate bond market. This, that the Fed can potentially buy a lot, helps making the program credible and thus helps explaining its powerful impact.

Dilemmas

Given the success of the PMCCF and SMCCFs, commentators have started arguing that the Fed should be allowed to buy corporate bonds as part of its standard toolkit (link). This might be relevant, but purchases of corporate bonds by central banks raise a number of dilemmas:

  • Keeping zombie firms alive. By easing up stresses in corporate bond markets, the Fed calmed down markets. This was the intention of the PMCCF and SMCCF announcements and it worked. It eased access to funding for firms, and firms have raised a lot of cash as a consequence (link). It is positive that malfunctioning markets are stabilized, but if central bank intervention makes markets too cheerful it may allow firms that in principle should not receive funding to nevertheless get it. And, thereby, to keep firms alive for too long, and increase firm leverage too much. Basically, the fear is that programs such as the PMCCF and SMCCFs create too many zombie firms. My CBS colleague Fabrice Tourre and his co-author Nicolas Crouzet has an interesting paper that examines this (link). Fabrice and Nicolas find that when financial markets work perfectly (no disruptions), Fed intervention might be detrimental to economic growth. On the other hand, if markets are disrupted, Fed intervention might prevent a too large wave of liquidations. One thus needs to determine when markets are disrupted “enough” to rationalize interventions in credit markets. This is no straightforward task.
  • Distributional aspects. By buying some bonds but not others, the Fed exposes itself to the critique that it helps some firms at the advantage of other. To alleviate such criticism, the Fed has been very transparent and publishes a lot of information about the bonds it buys, the prices at which it buys the bonds, etc. (link). Nevertheless, it is easy to imagine that some firms at some point will start saying ‘Why did you buy the bonds of my competitor, but not my bonds’?
  • The Fed put. The more the Fed intervenes when troubles arise, the more investors get reassured that the Fed will also come to the rescue next time around. When the Fed saves markets, it is sometimes called the Fed exercises the “Fed Put”. The potential problem here is that if investors believe that the Fed will exercise the Fed put, investors will be tempted to take on even more risk. Those of us concerned about systemic risks get nervous.

So, in the end, the announcement of the PMCCF and SMCCFs was crucial during this crisis. There are, however, important dilemmas that need to be addressed when evaluating whether such programs should be part of the standard toolbox. I am not saying they should not. I am saying that one needs to be careful.

Conclusion

The Fed launched massive “traditional” interventions in late-February/early March, lowering the Fed Funds Rate and buying mortgage and government bonds. In spite of these very large interventions, equity and credit markets kept on tail spinning. When firms struggle, it hurts economic activity and employment. The Fed got nervous.

The Fed announced – and this is the whole point here; they only announced – that they would start buying corporate bonds. Markets turned upside down. Credit markets stabilized, credit spreads narrowed, corporate bond-market liquidity improved, and stock markets cheered. And, all these things without the Fed spending a single dime until several months after the fact. Even today, the Fed has spent very little (some might say that USD 12bn is a lot, but compared to asset purchases of USD 3,000bn, it pales).

It was a “Whatever it takes” moment. It illustrates how managing investor expectations can be crucial. Understanding this announcement is thus important for understanding the behavior of financial markets during this pandemic.