Central Bank Action – Fixing Liquidity vs Solvency Risk

Central banks around the world have stepped in aggressively in the wake of the devasting effects of the Covid-19 virus. What do they hope to achieve and how effective will they be?

We see two very broad goals with different levels of effectiveness:

1. Liquidity Risk - fix the plumbing of the financial system to prevent collapse and further infection of the economy.
2. Solvency Risk - promoting an economic recovery via easier policy measures.

Liquidity Risk – Monetary Policy to Fix the Plumbing

Central banks have stepped in with unprecedented creativity to try and stem risks of a financial system collapse brought on by the massive economic downturn. Some of the same play book used in 2008/2009 was dusted off by the FED and other central banks. But they have also gone beyond. For example, the Bank of Canada began the purchase of high-quality corporate debt as that market essentially froze for a few days near the end of March and into the first part of April.

The goal is ensuring the smooth running of the financial system to prevent even further or more prolonged economic hardships – preventing sand from getting into the gears!

On that front there has been notable success with some of March’s key stress points abating. Improvement in various liquidity measures, credit metrics and market functioning indicators suggest a recovery in conditions from March’s lows is underway. For example, Financial Conditions Indices such as the ones below are well off their lows.

The FED and other central banks have aggressively expanded their asset purchase programs to include the purchase of various ‘spread’ products including credit ETFs. These programs mainly target government bond purchases that will sit on central bank balance sheets for years to come to cap yields, given the supply pressure with increased issuance (US example below). To tempt lending and borrowing, some clarity around future levels of rates are an important factor in credit flows. Forward guidance, we expect, will be a strong element of further support of smooth market functioning.

Solvency Risk – Monetary Policy to Fix the Economy

The liquidity risk that central banks are successfully tackling needs to be distinguished from solvency risk. The question to ask is how will central bank policies affect the real economy going forward?

Easing financial conditions in theory should grease the wheels of the economy to aid in its recovery. But the unique environment surrounding this economic slowdown/collapse may cause some delay. Due to uncertainty surrounding this pandemic, consumers and business may be unable right now to take advantage of low interest rates, higher liquidity and the easy monetary backdrop (money supply growth shown below)

Medical advancements on the virus are of course a key to this part of the equation. It is uncertain how quickly social distancing measures can be safely removed allowing consumers out into the economy to spend.

Meanwhile headwinds continue to exist such as rising consumer debt levels (which could lead to higher savings rates and deleveraging in the future), and the increasing risk of insolvency for businesses. This will result in higher unemployment, and precarious personal finances – which could keep aggregate demand low. This economic uncertainty could potentially outweigh the benefits of easy monetary policy for some time.

In many ways dealing with the solvency risk has fallen to governments through fiscal spending. Various measures have been introduced in support. Central banks have and will be used as a delivery mechanism (i.e., like in 2008 with the Troubled Assets Relief Program in the US and the Bank of Canada’s support of allowing banks to exchange illiquid mortgage assets for debt issued by the CMHC). But it will be governments bearing the risk of their support programs. So far, the fiscal response has been massive, but the staying power of this spending may come into question as deficits run higher, politics muddy, and if the virus lasts longer.

Our View

Central banks have reacted quickly and aggressively and have seen the fruits of their efforts in reducing the systemic risks of a major failure in the financial system.

When it comes to the efficacy of central bank policy in supporting and even improving the economic backdrop, the water gets a little muddier. The responsibility here lies more with fiscal and government spending to get business and consumers over the hump. The path of the virus creates economic uncertainty which may hold back the effectiveness of the easy monetary policy environment.

Portfolio Implications

Central banks will likely be slow in removing monetary policy accommodation which could result in rather robust growth on the other side of the virus. This has us cautious in the near-term given the market runup, but more constructive longer-term. We have been and will continue to use pull backs in risky assets as buying opportunities.

For government bonds, the competing forces of massive increase in government bond supply vs. central bank QE and investor demand are a key dynamic. We are recommending small underweights to duration within portfolios, as we do feel there is some scope for yields to rise and curves to steepen given:

1. some light at the end of the tunnel on the virus, along with
2. massive issuance pressure to come.

However, we feel yields are somewhat capped as central banks will be proactive through forward guidance or even yield curve control in not allowing yields to rise too far too fast and cut off the economy recovery. It makes sense to continue to add some higher quality corporates, funded from government exposure, at the margin.