Fed

Dwight Cass

Fed Brings Knife to Gunfight

The Fed is not only no longer a credible player, it’s actually causing measurable harm. Investors, hoping for something useful to come out of the G-7 conference call this morning, reacted to the central bank’s 50 basis point rate cut by driving the Dow and S&P down 3.5 percent by early afternoon. It would have been wiser for Powell and Friends to keep silent, sequestering their dwindling monetary ammunition for another day, when it might have done some good.

Even stock market investors understand that the Fed is making a category error. The Fed boss may have a hammer, but this crisis isn’t a nail. Specifically, unlike the Global Financial Crisis, when rate cuts helped ease pressure on bank balance sheets, Wall Street just isn’t the problem this time around. The industry’s solipsism makes it hard for bankers, and by extension, the Fed, to understand this. But this time, the trouble stems from events outside their purview. As Wolf Richter put it in a post earlier today, “Disappointed the Fed didn’t print antibodies?”

Worse, the Fed’s move could contribute to trouble in bank-land. In a note out yesterday, Fitch analysts warned that a rate cut could hurt bank profitability. With historic levels of marginal investment-grade debt about to slide off the cliff, and the leveraged markets looking increasingly parlous, banks don’t need this kind of trouble:

Fitch sees near-term downside to profitability due to asset yield compression while the yield curve falls at a historical pace, with the 30-year rate hitting an all-time low, as the Fed indicated that it would use necessary tools to support the economy. While we expect that banks will attempt to be quick in their response to cut deposit and other funding costs accordingly, these actions will not likely be to the same degree that asset yields compress, resulting in lower margins and reducing overall profitability, at least in the near term. Fitch notes the 30-day LIBOR forward curve dropped 25 bps during February, which could significantly affect loan yields during 1Q20.

That’s not apocalyptic, but it’s not great news, either, especially as the biggest US bank dealers – the eight so-called systemically important ones – boosted their equity holdings by 20 percent last year, to $454.5 billion, according to Risk. Luckily, they increased their stock of Treasuries by 28 percent, to $345.4 billion. The latter are rallying.

It is almost a relief to see the Fed out of the game, like a tennis star who has missed an easy volley staring dumbly at his racket, looking for the hole. The invective spewed at the Fed by Trump and his Tammany-on-the-Potamac enablers was dispiriting before; now it is a policy-ossifying distraction. On to the next bad option.

Dwight Cass

Credit is the Emerging Bogeyman for Debt Dystopia

The downgrades of Macy’s and Kraft Heinz hint that the next corporate debt catastrophe might not be caused by a wall, but a cliff. The Wall of Maturities that so worried leveraged loan, junk bond and CMBS investors at various times after the Global Financial Crisis turned out to be easily vaulted. The real problem, according to an OECD report out today, might be the massive amount of debt clinging to the bottom rung of investment grade. Macy’s and Kraft Heinz lost their footing. If others follow, things could get interesting.

Wall Worriers were concerned that the junk bond and loan markets would not be able to absorb the massive amounts of debt that had to be refinanced from around 2012 through 2014 – much of it loans used to finance the pre-crisis buyout boom. The CMBS reckoning was thought to be coming a few years later.

But the Fed, ECB and other central banks came to the rescue. By driving down yields on moderate- and low-risk investments, they forced pretty much everyone to slide down the credit spectrum in search of yield. Junk issuers found plenty of indiscriminate demand, the brains on which zombie companies feed.

The OECD report highlights another big problem, and one that central banks will not be able to solve. This is simply that the flood of nonfinancial corporate bonds – some $2.1 trillion was issued in the wake of the Fed’s dovish turn in 2019 alone – is near junk. “Just over half (51%) of all new investment grade bonds in 2019 were rated BBB, the lowest investment-grade rating,” the report states. This is even more dismal that before the financial crisis, when only 39% of investment grade issues were rated BBB.

The proportion of junk bonds has also increased, to 25% of nonfinancial corporate issuance last year, and over 20% since 2010. That’s the longest period of high volumes of low-quality issuance since 1980, and, the OECD says, “indicates that default rates in a future downturn will likely be higher than in previous credit cycles.”

If more economic stalwarts like Macy’s start to circle the drain, or the coronavirus so messes up supply chains and distribution lines that many marginally investment-grade companies run into trouble, large numbers of issuers could cross the line into junk status, forcing investors who cannot hold high yield instruments to sell. Large-scale forced selling of distressed assets – that has an unpleasant ring to it.