The US economy has suffered a massive heart attack, and the government, along with the Federal Reserve, have to build a fiscal and monetary policy bridge to help get the patient from here (middle of the heart attack) to there (recovery room). While the typical recession sees a modest contraction in output, this contraction is enormous as many industries have come to a complete standstill.
Given the massive scope of this contraction, the fiscal and monetary authorities have to step in and provide the type of medicines that are sorely needed, namely:
- The government is rightly working on a fiscal package to aid the industries and workers most affected. Yes, $2 trillion is a lot, but it aims to plug a similar-sized economic contraction.
- The Fed is easing policy and becoming the liquidity provider of last resort by creating an alphabet soup of programs targeting various lending markets.
What does this mean for the markets?
After lots of carnage, we are starting to see some positive developments on the liquidity front thanks to this Fed action. Equity markets cannot sustainably rally if the credit and funding markets are broken. This is why what the Fed is doing is so important. It significantly addressed and brought relative stability back to the Treasury market (off which spread assets are priced) and high-quality fixed income assets like agency mortgage-backed securities (MBS). Then, it went further down the chain to target the front end of the investment grade corporate market—a market which had developed huge dislocations (i.e., massively inverted credit curves) due to liquidity needs. By stabilizing the high quality end of the market (Treasurys and agency MBS) and then providing liquidity at a known price to other parts, the ground is being laid for an eventual market normalization (exhibit 1). Not surprisingly, high yield was not included in any of the Fed's programs. Clearly the Fed does not want to take the material principal risk required to get into the junk bond business and, thus, we think credit defaults in this space are likely to increase.
Exhibit 1: US Bloomberg Barclays Fixed-Rate MBS Spread to Treasurys
Source: Bloomberg Barclays. As of 3/25/2020.
Overall, we believe we are seeing the necessary responses to the crisis from both government and monetary authorities to build the bridge to normalization. While this is helping to restart credit flowing in the system, which supports asset prices, we reiterate our caution on the low quality part of the risk spectrum as we see an increasing probability of a new default cycle coming.
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