The global economy sank into the abyss on March 16, 2020. COVID-19 brought country after country to a standstill, disrupting manufacturing supply chains and service sectors. Global US dollar liquidity had dried up and recession risks were skyrocketing. In Europe, corporate credit default swaps trade with a probability of default of around 38%. As confirmed cases of COVID-19 have risen from less than 10 in January to nearly 165,000scientists speculated desperately about death and transmission rates.
Market players, meanwhile, were on their toes. As the feeling changed from worry to panic, the crash began. The Dow Jones ended the day down nearly 3,000 points. The S&P 500 fell 12% and the NASDAQ 12.3%. It was the worst day for US stock markets since Black Monday 1987.
Resuming its Global Financial Crisis (GFC) playbook, the US Federal Reserve sought to calm markets and extended immediate liquidity to prevent a pandemic-induced domino effect. Before the market opens on March 16, 2020, the Fed entered into swap agreements with five other central banks in order to ease the pressure on the global supply of credit. A few days later, the Fed entered into similar agreements with nine other central banks.
But it wasn’t enough. Before the end of March, the Fed extended its provisions to even more central banks holding US Treasury securities, including Saudi Arabia. These central banks could temporarily swap their securities held with the Fed to access immediate US dollar funding so that they do not need to liquidate their Treasuries.
Liquidity support for US dollar borrowers will always be an option for the Fed. Such interventions show that the central bank is committed to mitigating problems of economic instability and protecting the economy from financial collapse. Short term.
But what about the long term? Does such rapid – and often predictable – action increase the vulnerability of the financial system? Does it create moral hazard for central banks and market participants?
The state an economy finds itself in when the crisis hits is important. Thanks to stricter regulation and the evolution of the Basel accords, banks are now more resilient and better capitalized than they were before the GFC. They are not the primary concern. But the economy is more indebted and is even more vulnerable to shocks. In 2020, total global debt soared at a rate not seen since World War II amid massive monetary stimulus. By the end of 2021, global debt had reached a record US$303 trillion.
This excess debt has created increased systemic risk, particularly in the context of the recent spike in interest rates. Businesses stuffed themselves with credit in the era of easy money. Knowing that policy makers would intervene in times of turbulence, they failed to create a margin of safety.
Recent market volatility – the brutal clashes between bulls and bears – has been fueled by speculation about what the Fed will do next. The back and forth has been repeated often this year: Bad economic news sends bulls racing in anticipation of a potential Fed pivot to lower hikes, while strong GDP growth or jobs numbers fuel the bears, increasing the odds that the Fed will stick to its guns. Today, ahead of the December Federal Open Market Committee (FOMC) meeting, equity markets again grabbed a bid on hopes of a pivot.
The Fed first hiked rates last March, so the current hike cycle isn’t even a year old. Yet indebted companies are already showing strains. How many more rides can they sustain and for how long? Preventing runaway inflation is key, but so is dealing with the inevitable consequences through carefully crafted fiscal policies that consider the broader economy.
As investment professionals, we must anticipate the long-term challenge. Today, the threat is clear: the higher interest rate environment will expose financially indebted companies. This means that risk management must be among our top priorities and that we must hedge the cycle of rising interest rates. Active asset and liability management requires us to look beyond the accounting impact and focus on economic value of equityamong other measures.
The bottom line is that amid economic turbulence, the solution to the impending threat often creates greater long-term dangers. We must avoid speculating on when or if central banks or regulators will intervene. We must also remember that just as every economic downturn has unique causes, there are also unique remedies.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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