Cumulatively the markets are at or near record highs in illiquidity.  What makes this collapse so devastating is the breadth of illiquidity across most sectors of the market.  

The Volcker rules that were passed in 2009 to protect banks had unintended consequences.  Banks stopped making markets in corporate bonds, and there is no one now to take the other side of the trade.  US corporate debt is over twice the size it was in 2007, and there is less liquidity today than before the Great Recession.  The movie theater is on fire, and there is only one fire escape.   

On Friday, March 20th,we had a conference call with a PM for a multi-billion dollar pool of commercial paper.  He explained how the Fed’s Commercial Paper Funding Facility (CPFF) was not helping the markets because it is/was targeted to large banks and AAA credits.  Unlike 2008, the problems are not currently with financial institutions but spread across most of corporate America.  He gave an example of an A graded credit that was going to mature in 5 days and that the seller in search of liquidity took a 2% haircut for cash.  The seller lost 2% because they couldn’t wait for five days!  

You can clearly see this dislocation by the pricing of commercial paper-based ETFs.  On February 28th, the value of the MINT ETF was 101.77.  As of March 25th, the value was 97.45.  That is a loss of -4.4%.  100% of that loss is attributed to mark-to-market accounting, meaning that none of the commercial paper had defaulted, so technically, there are no losses. The desperate need to sell is crushing the best paper you can buy on the street forcing everyone who still owns this paper to re-price their book to the last bid that was hit.  

On Monday, March 23rd, the Fed announced unlimited quantitative easing and expanded their purchases to cover most of the investment-grade universe.  Here are the facilities they will be launching via their most recent announcement https://www.federalreserve.gov/newsevents/pressreleases/monetary20200323b.htm:

  1. Flow of credit to employers, consumers, and businesses by establishing new programs that, taken together, will provide up to $300 billion in new financing. The Department of the Treasury, using the Exchange Stabilization Fund (ESF), will provide $30 billion in equity to these facilities.
  2. 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.
  3. Establishment of a third facility, the Term Asset-Backed Securities Loan Facility (TALF), to support the flow of credit to consumers and businesses. The TALF will enable the issuance of asset-backed securities (ABS) backed by student loans, auto loans, credit card loans, loans guaranteed by the Small Business Administration (SBA), and certain other assets.
  4. Facilitating the flow of credit to municipalities by expanding the Money Market Mutual Fund Liquidity Facility (MMLF) to include a wider range of securities, including municipal variable rate demand notes (VRDNs) and bank certificates of deposit.
  5. Facilitating the flow of credit to municipalities by expanding the Commercial Paper Funding Facility (CPFF) to include high-quality, tax-exempt commercial paper as eligible securities. In addition, the pricing of the facility has been reduced.

The Fed is now the buyer of last resort as no one but the Fed has a balance sheet large enough to absorb these risks.  These facilities take more time to implement, but we are starting to see their effects. 

The commercial paper facility created by the Fed is also now able to purchase A2/P2/F2 paper (which is of a lower credit quality) but open to a much wider array of businesses than the investment-grade AA commercial paper. Yields on the 3-Month A2/P2/F2 paper dropped thanks to the Fed’s intervention, halting the rapid increase in yields that have exploded due to the crisis. However, yields on the AA Asset-backed commercial paper are increasing strongly – despite a small decline last week – potentially signaling unaddressed stress levels in the MBS market. 

Disturbingly, the FNMA/10Y Treasury spread has widened significantly and has not consistently gone down. This shows significant stress, comparable to the stress levels seen in late 2007, as the mortgage crisis started to become apparent. Although the Fed MBS purchases have been effective at stopping the rapid increase in yields, they are yet to lower them significantly. Since this is now coupled with a sharp decline in new home sales – no new mortgages – this might forecast extreme stress in the MBS market, potentially leading to a chaotic unraveling of the market, in some respects similar to 2008.

On the currency swap side, we see a recovery of conditions in the EUR swaps, with the recovery now reaching levels only seen prior to the collapse of the equity markets in early March. This is very important as the Euro-Dollar complex trades the largest volume and is, therefore, the most critical to the proper functioning of financial markets.  This is excellent news, indeed!

The JPY swaps are yet to show a similar recovery, but this is somewhat expected, given the higher demand for JPY relative to the USD during crisis periods. 

There is significant pressure on other currencies, like the AUD, which showed intense downside pressure in their swaps, even after the Fed started offering direct swap lines to its central bank. This indicates that the USD shortage is far from over, but the worst effects will probably be negated if the Euro-Dollar complex continues to improve. 

The Fed removed their cap on treasury purchases at the start of the week, making a commitment to buy as many treasuries as required to keep the market functioning properly. Including TIPS, the Fed is purchasing $75 billion in US Treasuries per day, which is more than they bought per month in QE3.  So far, the Fed has purchased around $266B in Treasury securities (excluding TIPS), and the accepted/subscribed ratio for operations now varies between 0.5-0.7.  The cumulative ratio is slowly trending upwards, as we have observed during previous weeks. This means that the Fed continues to successfully battle pressure against higher yields in treasuries across the curve. 

As we prepare this letter for publication, the Governor of Idaho just held a press conference where he announced that they are shutting down the state for the next 21 days. There is an uneasy feeling in the air as the enemy approaches.  Be safe and good trading in these difficult markets.