Policy focus: unfreeze bond markets, prepare for the “intentional recession”

Brian Nick

The last week’s market highlights:

Quote of the week:

“If you’re going through hell, keep going.” – Winston Churchill

Houston, we have a liquidity problem      

As the coronavirus continues to exact a terrible human toll around the world, the market and economic fallout from the outbreak keeps spreading as well. Among the most serious threats: an extreme liquidity crunch in global bond markets amid forced selling and panicked flights to cash. This has caused yields on high-quality bonds—including U.S. Treasuries—to jump over the past two weeks. If left unaddressed, the liquidity squeeze will create a further severe tightening in financial conditions, weakening the economy in the short term and making the eventual recovery from the virus-driven downturn less robust.
The Federal Reserve has acted decisively by cutting interest rates to zero and announcing $700 billion of asset purchases to try to ease monetary policy. (Remember quantitative easing, or QE? It’s back in a big way.) And last week the Fed revived several more of its financial crisis-era programs:
  • Commercial Paper Funding Facility (CPFF) — direct cash injections into the short-term commercial paper market used by non-banks to fund short-term liquidity needs. This helps large companies meet payrolls and eases selling pressure in money market mutual funds, many of which hold commercial paper and were selling it to meet redemptions.

  • Primary Dealer Credit Facility (PDCF) — direct cash loans to primary dealers (institutions that can buy U.S. Treasuries at auction) in exchange for a variety of collateral. This program is intended to preclude the need for dealers to force-sell government, government-related, corporate, and municipal bonds to raise cash.

  • Money Market Mutual Fund Liquidity Facility (MMLF) — cash in exchange for assets of money market funds. This facility aims to (1) support the short-term securities typically held by money market funds and (2) prevent a money market fund itself from “breaking the buck,” i.e., falling below $1 in net asset value (NAV).

  • Central bank U.S. dollar swaps — currency exchanges between the Fed and non-U.S. central banks to alleviate surging overseas demand for the dollar—the world’s reserve currency. The exchanges initially included major central banks but expanded late last week to include those in countries like South Korea, Mexico and Brazil. (Financial Times)
Along with the massive and rapid deployment of QE’s direct asset purchases, these measures and ones like them from the European Central Bank, Bank of England and the Bank of Japan should have a noticeable effect as they did in 2008 and 2009. And the Fed may yet have to go further to deliver true “shock and awe” by partnering with the U.S. Treasury to guarantee loans made to small businesses or backstop the municipal and corporate markets. These could require acts of Congress, and time is of the essence.

The coming recession will be deep by design  

The coronavirus recession is going to be far deeper than we thought even a week ago. Indeed, our recent U.S. GDP forecasts for the second quarter didn’t account for nearly a big enough drop in the second quarter. What changed in so short a time?
  • In China, private-sector activity—retail sales and business investment—turned out to be roughly 20% below its level at this time last year.6 This was a larger decline than anticipated and gives us a better idea of what to expect in other countries.

  • The U.S. and Europe have moved much more quickly to enact social distancing strategies (e.g., school closures, shuttered businesses, shelter-in-place edicts) than we expected.

  • Early reports of layoffs across a broad sample of states have been dramatic.

  • Financial conditions have continued to tighten despite efforts from the world’s central banks so far.
Against this backdrop, second-quarter U.S. GDP forecasts from leading economists have ranged from “optimistic” (the economy will shrink at a 2%-3% annualized rate in the spring) to “pessimistic” (declines in the -10% to -15% range). In this context, “optimistic” and “pessimistic” are in quotation marks to highlight the paradox of the coming downturn: The worsening growth outlook actually reflects a stronger commitment to eradicating the coronavirus. In other words, the coming recession is intentional.
If no mitigation strategies were being attempted, the economy would not perform as poorly right away, but the health care crisis would likely become far more destructive. Biting the economic bullet today, as painful as that may be, is more likely to produce a V-shaped recovery—or any recovery—than using half-measures to contain the virus.
Beyond the extraordinary monetary stimulus described earlier, the U.S. and other nations are also putting together massive government spending programs to combat the looming recession. A fiscal package totaling close to $3 trillion is possible in the U.S. alone, in our view. This would help make the economic ditch shallower and the bounceback higher in future quarters.
In the meantime, the ongoing uncertainty is making it very difficult to price risk assets such as stocks and higher-yielding fixed income categories. Among the critical unknowns are the path of the virus itself, the depth and length of the recession, its impact on corporate profits, and the ability of financial markets to function properly amid the turmoil.
What does this mean for individuals? We continue to believe that diversified, long-term investors are best served by resisting the temptation to join in the selloff. You can learn more about weathering these volatile markets with guidance from TIAA and register for a live webinar scheduled for Wednesday, March 25.
  1. U.S. Employment and Training Administration via FRED; MarketWatch.
  2. FactSet.
  3. FactSet. Europe = STOXX 600 Index; Japan = Nikkei 225 Average; Emerging Markets = MSCI EM Index. All returns in U.S. dollars.
  4. FactSet. Investment-grade bond returns = Bloomberg Barclays U.S. Corporate Investment Grade Index; high-yield bond returns = Bloomberg Barclays U.S. Corporate High Yield Index (2% issuer capped).
  5. U.S. Treasury Department.
  6. Bloomberg, L.P.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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