Eddie explains how COVID-19 disrupted supply chains and demand, prompting the Fed, ECB, and Bank of Japan to expand balance sheets beyond $6 trillion and buy junk bonds. When liquidity dried up, oil futures went negative and bid-ask spreads widened. The ECB now accepts downgraded "fallen angels" as collateral, risking forced sales that could destabilize markets.
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Hi guys, Eddie here with another video. Today we're going to be discussing quantitative easing, liquidity, and falling angels. And if you haven't checked the content, uh, that the guys have put out over the last few days, it's fantastic. So go on to the YouTube channel, check that out, and subscribe if you haven't already. As a result of the coronavirus, of course, we've seen huge supply chain disruptions, uh, huge demand shocks, to equity markets, companies, oil, everything. And it's led to so many unprecedented things taking place. Global central banks have stepped in to pump artificial liquidity and support markets. Okay, so the Federal Reserve balance sheet has exceeded $6 trillion to backstop this coronavirus crisis. It has tapered off, uh, their treasury purchases somewhat, but this This is still going at an incredible pace. They're purchasing things like US Treasuries, mortgage-backed securities, investment-grade bonds, and more importantly, junk bonds. This is the lowest-rated debt that a company can issue. They've expanded their purchases for this lower-quality debt. This is as a result of basically companies tapping the debt markets for liquidity to basically offset their revenue shocks, their cash flow shocks, so they survive. And as a result of this, companies have actually been issuing their debt at a record pace to offset this. And the Fed have basically taken the other side. So they're going to buy the debt that these companies are selling. And this is forecasted— the Fed balance sheet to hit $9 trillion by mid-year 2020. And this is the call coming from Evercore. They actually got to a point where they're purchasing $1 million of assets. Per second. Okay, so this is extreme conditions leading to an extreme emergency response from the Federal Reserve, and this is basically to ensure that the credit markets, the high-yield markets, are functioning and they're liquid. Okay, so all central banks are doing this— the European Central Bank, the Bank of Japan, the Federal Reserve— they're all pumping artificial liquidity to these companies, to these markets, and we're seeing serious moral hazard on our hands as these companies are racing for liquidity because they know these central banks are gonna buy up their debt. This is potentially keeping firms that should fail, zombie companies, in business, and this is rewarding excessive risk-taking and undermining capitalism itself. So it's extremely worrying that we're seeing this, but it's necessary at the moment. First of all, we have to understand liquidity, okay? And this is basically a slide showing the bids, so the buyers in the market, and the offers, okay? So this is showing a very liquid market, okay? And this is something like the US Treasury market or the FX market. In times of extreme stress and shock, what we see is actually less buyers and sellers in the market. And this is actually what we saw a few weeks ago in the US Treasury market. And this is extremely worrying and led to the emergency responses from the Federal Reserve. Basically, when there's stress in something like the US Treasury market, this is extremely worrying because lots of other assets and derivatives are priced off this 10-year yield. So if there is stress in this market, this can cause huge problems for the global economy. Okay, if there's less buyers and sellers, when someone places a trade or buys or sells a normal amount of this asset, this could exacerbate price movements. And this is basically what we saw with oil over the last few days, where speculators were holding these oil futures contracts, the May ones, and they were basically dumping them because they didn't want to take this, um, basically delivery of physical oil. So there was no one willing to buy this futures contract they were trying to sell, so the price went below zero, which is crazy. So these bid-offer spreads tend to rise in volatile markets because banks and other basically intermediaries are reluctant to hold this inventory, and the cost of training, despite the Federal Reserve and other global central banks stepping in is still about 3 times the average in investment grade credit that we saw before the coronavirus. And this has been exacerbated again by the move of some broker-dealers staying at home because of the virus lockdown, and this is reducing their ability to transact. So what we saw out of the eurozone today is extremely poor PMI. So this is the Purchasing Managers Index. So this is just another poor piece of data coming out of Europe, and this has led to the European Central Bank, uh, basically speculating that they're going to take extreme measures. So the Europe, just like the whole global economy, uh, is in intense contraction. Uh, economic activity is plummeting, and actually markets, uh, have diverged quite considerably from actually the economy. And this is something I was watching, the Federal Reserve balance sheet that we referred to on any other slide. Over the last 10 years, the Federal Reserve balance Fed's balance sheet and the equity markets have basically gone in lockstep and gone up together. Okay, what we saw in March was the equity market sell-off and that correlation breakdown quite dramatically. Since then, the equity market and the Fed's balance sheet, as a result of this artificial liquidity, have both gone up again and that correlation has returned. Okay, so now the ECB have actually stepped in to loosen their collateral rolls to accept something called falling angels. So what are falling angels? Falling angels are essentially companies that are rated in the investment grade space. So you have this whole spectrum of credit ratings by lots of different rating agencies. So S&P, my old company, Moody's, Fitch, and they rate companies according to the creditworthiness— how, how basically able are they and how willing are they to repay their debt. So when you see extreme stress So revenues, cash flows drop off. This puts companies obviously in severe credit crises, right? So they will be downgraded by the credit rating agencies from this investment grade to the speculative grade, high-yield junk space. The markets have been downgrading these companies far faster than the credit rating agencies, and there's going to be a lot more to come. So UBS have come out of a great stat. Since 2011, European bonds rated triple B-, one notch above junk status, has ballooned from $330 billion to $1.14 trillion. Yet double-B-rated bond issuance in the high-yield market has risen from $74 billion to $185 billion in that time. About $275 billion of non-financial corporate bonds could become falling angels and downgraded within the next year. Um, so this is extremely worrying, um, and this is a result of the coronavirus affecting businesses' activity so much. The economy is shrinking considerably. And actually, as a result of that downgrade, investment companies, investment funds are no longer— some of them— allowed to hold this debt. So they would invest in companies that are only allowed to be investment grade. Now, when they're basically downgraded to junk, they won't be allowed to hold these assets anymore. So this is going to exacerbate the moves further. So the ECB has changed these rules and loosened them to basically accept these fallen angels. Okay, so this is not yet as far as the Federal Reserve have gone where they are actually buying the junk bonds. These are being taken as collateral, and the central bank said it was prepared to go further if it's required to avert a eurozone debt crisis. So this is extremely, extremely worrying. We're in unprecedented times where this coronavirus situation is impacting markets extremely considerably, and then we're going to see a huge amount of falling angels. This poses huge threats for all central banks across the world because they're meant to purchase assets that actually do not lose money. So we're all watching the situation as it develops, but it's going to be extremely interesting to see. I hope you enjoyed the video. Any concepts that you didn't understand, please write in the comment section below. I'm more than happy to answer questions. Any video requests, I'm more than happy also to do so. Take care.
