In March 2020, the new crown epidemic broke out in the United States; OPEC and Russia did not reach a production cut agreement, and international crude oil plummeted. The exposure of US corporate debt debt risk, the dollar liquidity crisis broke out, and the indiscriminate sell-off led to a sharp rebound in government bond yields and four meltdowns of US stocks. The rise in dollar demand in the foreign exchange market led to a rise in the dollar index. The TED index rose to 1.4% in March, although it was far lower than the level of the 2008 global financial crisis, but it was comparable to the 2007 subprime mortgage crisis. To this end, the Federal Reserve lowered the target rate of federal funds to 0% to 0.25%, launched open quantitative easing, and also launched a series of crisis response tools. What are the causes of the dollar liquidity crisis and how do they spread to various markets? Does the current Fed bailout policy fundamentally solve the liquidity crisis, and will there be recurrence during the subprime crisis? This article will analyze the causes and transmission mechanism of the dollar liquidity crisis and judge the effect of the Fed’s bailout policy.
This article analyzes in detail the evolution of corporate debt debt risk to the US dollar liquidity crisis, and finds that the widespread use of commercial bank liquidity supervision, long-term low interest rate environment and relative value strategies have accelerated the outbreak of the US dollar liquidity crisis, and the collapse of US dollar asset prices has caused Currency swaps US dollar integration party’s increased default risk has led to tight liquidity of the US dollar in the foreign exchange market. The Federal Reserve’s emergency bailout measures temporarily eased the liquidity tension of the US dollar, but while helping health companies overcome the difficulties, they also contributed to the potential risks of the problematic companies.
The Cause and Evolution Path of the US Dollar Liquidity Crisis
Transmission of American Corporate Bond Credit Risk to Market Liquidity Risk
The liquidity crisis in the US dollar market was caused by the credit risk of US corporate bonds. Prior to the impact of the epidemic, the potential structural risks of US corporate debt were already present. According to BIS data, in the third quarter of 2019, the leverage ratio of US non-financial enterprises was 75.3%, which was lower than the average level in developed countries and higher than the level during the crisis in 2008. But compared to the leverage ratio, the more prominent issue of US corporate debt is the decline in debt quality. First, the proportion of low-rated corporate bonds has risen. As of March 26, 2020, the size of US investment-grade corporate bonds was approximately US$6 trillion, half of which were BBB-grade corporate bonds, approximately US$3 trillion. BBB-rated bonds are quasi-junk bonds. Once downgraded, it is easy to trigger an institutional sell-off. The second is that American companies have sufficient solvency under normal operating conditions, but their debt resistance is poor when they encounter external shocks. Take the S&P 500 enterprise as an example. According to the 2019 annual report, the median interest coverage ratio of S&P 500 companies is 6.84, which is relatively high and sufficient to meet the debt repayment of enterprises under normal operating conditions; but the median quick ratio is only 0.95, which is lower than The normal requirement of 1, that is to say, once an enterprise’s revenue has deteriorated due to external shocks, the company’s existing current assets alone are not enough to repay the company’s current liabilities. The third is that some industries that have been hit hard by the epidemic have inadequate solvency. For example, the energy industry that was hit hard by the epidemic. In 2019, the median interest coverage rate of US stock energy companies is 1.2, while oil companies have a lower interest rate of only 0.16. Fourth, the use of corporate debts is unrealistic. In order to push up stock prices and earnings per share, a large amount of corporate debt is used to repurchase stocks or pay dividends and other non-productive investments, leading to a serious overestimation of the company’s market value. In November 2019, the Federal Reserve in the “Financial Stability Report” specifically reminded companies of debt risk, that U.S. companies leveraged loans and high-yield bond issuance accelerated.
In March 2020, the overseas spread of the New Crown epidemic and the plunge in oil prices caused severe damage to the US aviation, energy, and service industries, which directly hit the potentially risky US corporate bond market, especially energy corporate bonds with weak debt fundamentals. The industry’s credit risk has increased, and the US high-yield credit spread has increased. In the first week of March 2020, the credit spread of BBB-grade corporate bonds widened by 20bp. In mid-March 2020, the credit spread of US low-rated high-yield bonds rose to more than 4%, which has exceeded the 2008 Lehman Brothers collapse, and the credit spread of high-rated credit bonds also rose rapidly.
Since the implementation of the “Volcker Rule” after the crisis also restricted the extent of commercial banks’ participation in the financial market, the liquidity crisis was mainly contagious through non-bank financial institutions such as mutual funds. Without considering other factors such as derivatives, the rise of corporate debt credit risk spreads through the collateral value channel and asset price channel into a liquidity crisis. See Figure 1 for details.
The rise in default risk leads to a decline in the value of collateral, and institutions face liquidity gaps. Relative to the price fluctuations of stocks and commodities, the fluctuations in bond yields are relatively small, so financial institutions often increase leverage to hold bonds to increase returns. If the fund increases leverage to hold $1 billion in credit bonds before the default risk rises, of which $900 million is held through pledged bond repurchase financing, then after the default risk rises and the corporate credit qualification declines, the primary dealer lowers the corresponding pledge The discount rate of the bonds, the fund can use the same size of credit bonds as collateral, and the US dollar can be reduced. The fund will face a new dollar gap.
Tight liquidity and downgrades triggered asset selling and formed a vicious circle. In order to fill the liquidity gap and meet the mutual fund investment high-yield debt ratio limit, the fund faces a decline in corporate debt credit rating, and can only choose to actively reduce leverage, sell off credit bonds, stocks and other risky assets, and increase holdings of treasury bonds and other risk-free assets (sovereignty The bond mortgage discount rate is 100%). At this stage, the price of risky assets fell, U.S. stocks continued to melt, and the 10-year U.S. Treasury bond yield quickly fell to 0.54%, a record low. However, the fall in the price of risk assets will lead to a further increase in the credit premium of corporate bonds, a further expansion of the institutional financing gap, and a further sell-off of risk assets. The rise in credit spreads, tight liquidity and falling asset prices will form a vicious circle.
Asset prices fell, the fund’s net worth fell, and redemption runs triggered indiscriminate selling. The rise in the credit premium, the stock price plunge, and the sharp decline in the underlying risk assets will inevitably cause the mutual fund’s net worth to fall, triggering the redemption of residents and businesses. In March 2020, the US long-term mutual funds continued to have net outflows, with a cumulative outflow of US$356.2 billion, exceeding the total net outflow for the entire year of 2019. Among them, bond mutual funds have the largest net cash outflow, with a monthly outflow exceeding US$239.8 billion. If sufficient funds cannot be integrated into the currency market, the institution will sell the assets held indiscriminately to meet the redemption requirements, and the asset sales will spread to risk-free assets. In the second week of March, treasury bond yields rebounded strongly by nearly 50bp, and international gold also fell sharply by more than $100 per ounce within a week.
Compared with the subprime mortgage crisis, this liquidity crisis is spreading faster
Generally speaking, it takes some time for credit risk to spread to liquidity risk. Take the 2007 subprime mortgage crisis as an example. In the second quarter of 2007, the United States already experienced bankruptcy of subprime mortgage institutions and losses of Bear Stearns’ funds. However, from the TED index, it was not until August 2007 that the subprime mortgage crisis evolved into dollar flow Sexual crisis. In March 2020, there were no large-scale financial institution bankruptcy or fund liquidation in the US financial market. It can be seen that the exposure of credit risk is far less than during the subprime mortgage crisis, but the speed and degree of the spread of asset prices and the spread of liquidity risk far exceeded the subprime mortgage crisis. period. This article believes that Basel III’s liquidity regulatory constraints, long-term low interest rate environment, and widespread use of relative value strategies have accelerated the outbreak of this liquidity crisis.
Financial institutions anticipate a decline in capital integration and are subject to LCR regulation to actively reduce capital outflows. In October 2013, the Fed announced a liquidity control plan mainly for large domestic banks, requiring the liquidity coverage ratio (LCR) of large banks to meet the requirements of Basel III (100%) in 2017, namely The scale of high-quality liquid assets that are not in a pledged state and the net capital outflow in the next 30 days shall not be less than 100%. When large banks observe that the credit risk of their corporate bonds rises, considering that the decline in the value of such asset collateral will lead to a reduction in the funds that can be integrated in the next 30 days, they will actively reduce the liquidity supply and sell risky assets to increase their cash holdings. And risk-free assets to meet regulatory requirements. In the evolution of the liquidity crisis, the Fed provided a large amount of liquidity to the financial market through repurchases in the early stage, but it did not prevent the spread of the liquidity crisis and the continued sale of assets. The main reason is that the liquidity placed by the central bank’s repurchase only flows to the primary dealers, and the primary dealers are subject to liquidity supervision, reducing the dollar financing of other financial institutions, blocking the transmission of market liquidity, and other financial institutions. Have to continue to sell assets.
The long-term low interest rate environment has kept the scale of US stock financing high, triggering a large-scale forced liquidation when falling. In March 2020, U.S. stocks suffered four meltdowns, unprecedented. The large increase in US stock financing since 2009 has exacerbated the decline in US stocks. The long-term rise of US stocks has made a large number of investors have better expectations of US stocks. The long-term low interest rate environment has also lowered the cost of financing shareholdings. Listed companies have also taken the initiative to repurchase their own stocks, and the size of US stock financing accounts has increased significantly. In December 2019, the financing balance of the US margin trading account was 579.2 billion US dollars, which was 3.27 times that of January 2009. The margin trading account balance was equivalent to that of the beginning of 2009, which shows that the market has high expectations for the rise of US stocks. Unlike the 2007 subprime mortgage crisis, the market did not have enough time to respond to sudden exogenous shocks such as the New Crown epidemic. It did not reduce financing and increase margin trading to hedge risks as before the subprime mortgage crisis. Therefore, when the price of US stocks plummeted, the margin of a large number of financing accounts was quickly insufficient, and investors suffered a forced liquidation, which led to further plunges in US stocks. The decline in US stocks will lead to an increase in corporate credit premium through collateral value channels, and liquidity tension will further ferment.
The widespread use of relative value strategies has led to the sell-off of national debt. Hedge funds that use a relative value strategy hold leveraged bonds and sell corresponding Treasury futures contracts at the same time. Hedge funds that use this strategy are intended to profit from the small price spreads/spreads between cash and futures. The use of high leverage will amplify these tiny gains and bring stable returns to the fund. When the pressure of asset selling has not been transmitted to risk-free assets, institutions purchase large amounts of risk-free assets to meet the need for hedging. The demand for USD liquidity in the futures market rose. In the case of a decrease in the supply of liquidity in the US dollar, institutions cannot integrate funds in time to meet the margin requirements, and the government bonds held will also be forced to be sold, and the yield of government bonds will rebound significantly. Furthermore, the scale of liquidity integrated with national debt as collateral has declined, and market liquidity has become more tense.
Transmission mechanism of dollar liquidity crisis spread to foreign exchange market
In the foreign exchange market, non-US financial institutions usually use currency swaps and foreign exchange swaps to obtain dollars from the offshore market. Due to factors such as transaction friction, liquidity stratification, and differences in institutional financing capabilities, CIP with no arbitrage may not necessarily be established. Since the 2008 financial crisis, the long-term implied dollar financing interest rate that meets the premise of CIP has been higher than the dollar onshore currency market interest rate for a long time, reflecting the long-term negative basis for the exchange rate between the major currencies and the dollar. If this basis is widened (the negative value is smaller), it means that most financial institutions have a higher cost of integrating the US dollar into the foreign exchange market, and the liquidity of the US dollar in the foreign exchange market is tight.
Since 2014, due to the Fed’s withdrawal from quantitative easing, the euro zone and Japan have gradually fallen into negative interest rates, and the relatively high return on dollar assets has caused non-US financial institutions represented by Japanese and European banks to increase their holdings of dollar assets in the foreign exchange market. Demand for financing and hedging increased. In the same year, the Fed introduced new regulations for the supervision of foreign banks, which reduced the ability of foreign banks to allocate dollars across borders, and the relatively high dollar loan interest rates also reduced the size of cross-border dollar loans. The imbalance between the supply and demand of US dollar financing in the foreign exchange market has led to a rapid expansion of the basis for the implied U.S. dollar financing rate and the onshore dollar Libor, and the dollar index has risen rapidly. Taking the basis swap of the Japanese yen and the US dollar as an example, from 2014 to 2016, the 3-month JPY-USD swap basis expanded from -20bp to -99bp, and the dollar index gradually rose to more than 100 during the same period. From the trend point of view, the dollar index and the JPY-USD basis have reversed fluctuations, the dollar index has fallen, and the JPY-USD basis will also narrow.
In March 2020, the liquidity of the US dollar appeared in the foreign exchange market, the JPY-USD basis quickly fell to -136bp, a record low, and the US dollar index rose to more than 100. Different from the increase in demand for US dollar assets by foreign institutions from 2014 to 2016, which led to an increase in demand for US dollars, the increase in demand for US dollars in the offshore market is due to the loss of large amounts of US dollar assets invested by foreign institutions in the early stage. As the risk of defaulting on US corporate bonds has risen and US stocks have plummeted, it has been difficult for the dollar-integrated parties in currency swaps to repay principal and interest due at maturity, resulting in a liquidity gap. At the same time, as an institution connecting the onshore and offshore markets of the US dollar, the supply of US dollars from the US dollar lenders also declined. First, in the face of the rising default risk of currency swap counterparties, the willingness to withdraw the US dollar declined. Second, the onset of the liquidity crisis in the onshore market also affects its ability to mobilize in the foreign exchange market. The imbalance between the supply and demand of US dollar financing in the foreign exchange market has intensified. The US dollar integration party only sells the local currency in exchange for the US dollar, or a new swap agreement is integrated into the US dollar to make up for the funding gap. Tension has also spread in the foreign exchange market through currency swaps (see Figure 2).
Can the Fed crisis toolbox in 2020 fundamentally solve the liquidity crisis
In 2020, the Fed has launched tools and a comparison with the subprime crisis toolbox
The causes of the dollar liquidity crisis and the subprime mortgage crisis are different, and the Fed’s focus on disposal is also significantly different. In 2008, the US government believed that the financial crisis mainly stemmed from financial supervision and internal problems in the financial system. In March 2008, the US Treasury Department launched the “Modern Financial Regulatory Structure Blue Book” and was aware of regulatory gaps, regulatory competition, and investor protection. After taking office, the Obama administration pointed its finger at financial supervision, launched the “Dodd-Frank Act” and introduced the Volcker Rule. In addition to crisis relief, the restructuring of the financial system and financial regulatory system was also the focus of the Fed’s attention at the time. The dollar liquidity crisis stems from the exogenous impact of the epidemic. During the spread of liquidity tensions, no one type of financial institution and mutual fund declared bankruptcy or liquidation, and the stability of the financial system far exceeded that of 2008. Therefore, the purpose of the Fed’s policy this time is not to restore the fragile financial system to health, but to maintain the continued healthy operation of the financial system and provide temporary credit assistance to businesses and residents to help the economic system maintain normal operation.
Compared with the rescue during the subprime mortgage crisis, this crisis rescue is more timely and targets more extensive markets and groups. The toolkit launched by the Federal Reserve this time is mainly divided into the following four aspects: One is to provide liquidity support for various domestic financial markets to restore the normal operation of the financial system as soon as possible, mainly including repurchase, QE (quantitative easing), PDCF (one Level dealers’ loan facility), MMLF (money market fund loan facility), CPFF (commercial paper loan facility), TALF (term asset-backed securities loan facility), etc. The second is to provide credit support to various bond markets to resume normal financing of enterprises and governments as soon as possible, mainly including CPFF, TALF, SMCCF (secondary market enterprise debt lending facility), PMCCF (primary market enterprise debt lending facility), MLF (Convenience of municipal debt liquidity); The second type of tools is actually a subset of the first type of tools, and is a liquidity tool with credit support. The third is to provide credit support to enterprises and residents affected by the epidemic to help them overcome temporary difficulties, including MSLF (mass lending plan) and PPPLF (payroll security scheme liquidity convenience). The fourth is to expand currency swaps with overseas central banks to prevent the crisis from spreading rapidly overseas through offshore markets. The frequency of currency swaps between the Fed and the five major central banks has been increased to daily, and it provides temporary currency swap facilities for all central banks and international institutions that participate in the U.S. financial markets and have New York Federal Reserve accounts.
The effect and potential risks of the rescue policy
Judging from the current policy effects, the market liquidity risk has been slightly alleviated and the asset price trend has returned to normal, but the low-rated credit spread and TED spread are still high, and the market is still vigilant against the liquidity risk of the US dollar. In early April, the TED spread decreased from 1.4% to 0.99%, institutional liquidity risk decreased, but it is still at a historically high level; the yield of 10-year Treasury bonds fell to about 0.6%, and the credit rating of high-rated corporate bonds The gap also returned to the level before the outbreak of the epidemic, but the credit spread of BBB grades is still at a high of more than 3%. In terms of the US dollar index, the current swap basis of major currencies and US dollars has turned positive with the support of central banks’ liquidity. However, due to the current return on US dollar assets relative to major developed countries, the foreign exchange market has not relaxed against the US dollar. Demand, the dollar index has not declined too fast.
Whether the US dollar liquidity crisis can be solved from the root cause also needs to pay attention to the credit risk situation of US corporate bonds. Different from the 2007 subprime mortgage crisis, the subprime mortgage crisis stems from excessive leverage by residents, and the risk is endogenous and the propagation time from the occurrence to the outbreak is longer; but the sudden exposure of US corporate debt credit risk mainly stems from unpredictable Exogenous shock. The plunge in oil prices makes it difficult for US shale oil companies to maintain production. G20 countries have joined hands to stabilize oil prices. Whether the initiative can be implemented and the future trend of oil prices remains to be seen. If oil prices continue to be too low, more shale oil companies may face bankruptcy. The global spread of the new crown epidemic has led to a decline in corporate operating income. Some companies have suffered from capital chain breaks and unable to repay principal and interest on time. The risk of corporate defaults that have been severely affected by the epidemic has increased. According to the current plan (April 10), the Fed will provide a total of US$950 billion in liquidity to the ABS market, commercial paper market, corporate bond primary market, and corporate bond secondary market, but the policy tool is limited in scale and can only For a while, whether the future corporate debt risk can be mitigated depends largely on the spread of the epidemic and the degree of prevention and control, with certain uncertainties.
Similar to the period of the subprime mortgage crisis, the Fed still has not identified the solvency risk and liquidity risk. The debt risk of problematic assets will be covered by a large amount of liquidity, which may become a hidden risk in the future. Starting in 2019, some corporate debt risks in the United States have begun to rise, and the US economy has shown signs of recession. The impact of the epidemic has caused some healthy companies to temporarily fall into trouble, and it has also allowed some companies with already fragile debts to break out of default first. However, the Fed still has not identified risks, the scope of indirect asset purchases for corporate bonds has been expanded to junk bonds, and credit support for SMEs has also relaxed the restrictions on shareholders associated with banks. The Fed’s large-scale liquidity investment may distort the allocation of financial resources, further delay the process of reallocating financial resources, and even breed a group of zombies. In the long run, excessive liquidity support may increase the debt risk of problem companies.
The dollar liquidity crisis is due to the exposure of US corporate debt credit risk. Prior to the outbreak of the epidemic, US corporate debt had revealed structural potential risks, and the outbreak of the epidemic exacerbated the exposure of debt risks of problem companies and industries, resulting in a substantial increase in the credit spread of related corporate debt. The rise in corporate bond credit spreads has evolved into US dollar liquidity risk through collateral value channels and asset price channels. Rising credit spreads, tight US dollar liquidity, and falling asset prices have formed a vicious circle. The collapse of the underlying assets has led to a sharp decline in the net value of mutual funds. It triggered a large-scale redemption run, the dollar liquidity crisis broke out, and assets were sold indiscriminately. The strengthening of liquidity supervision, the long-term low interest rate environment and the use of relative value strategies have accelerated the dollar liquidity crisis. The fall in asset prices has led to liquidity tensions in the currency-swap dollar integration side, the dollar liquidity crisis has spread to the foreign exchange market, and the dollar has appreciated.
In March 2020, the Fed responded to the outbreak of the US dollar liquidity crisis. The bailout was timely and involved a wide range of markets. It not only gave the market sufficient liquidity support to maintain the normal operation of the financial system, but also provided relevant companies and residents with bond credit and bank credit support. The liquidity risk of the US dollar was temporarily alleviated. However, the credit spread of low-rated corporate bonds is still high, and the TED spread is still at a relatively high level, which shows that the liquidity risk of the US dollar has not been fundamentally resolved. Because the Fed still selectively ignores the objective solvency risk this time, a large amount of liquidity and credit support may increase the debt risk of problematic companies and even breed a group of zombies.
This article believes that the rescue tools for corporate bonds are limited in scale and can only be maintained for a while. The future evolution of US corporate bond credit risk and US dollar liquidity risk depends on the extent and time of the spread of the epidemic. If the spread of the epidemic intensifies and the duration is too long, the long-term decline in demand and the breakdown of the supply chain will cause more companies to go bankrupt, and the credit spread of corporate bonds will further increase by then. If the Fed does not choose to bail out further, it will usher in a new round of liquidity tensions in the US dollar, asset sell-offs and dollar appreciation. If the Fed chooses to continue to provide counter-cyclical liquidity to all markets indefinitely, the spread between U.S. Treasury yields and Japanese and European bond yields may further narrow, and the cost of acquiring U.S. dollars in the foreign exchange market will fall. . However, if the epidemic is brought under control by the third quarter of this year, the US economy and the global economy are back on track, and the balance sheets of businesses and financial institutions will be repaired. If the US monetary policy returns to normal and the Fed withdraws from the temporary currency swap agreements with most countries, the strong dollar will remain.