Earlier this year, in April, when the COVID-19 pandemic was new, we provided blog readers with a handy guide to policy stress levels by defining COVID19 Policymaking DefCon Levels.
The recent round of statements and policy releases from central banks within the Group of Seven nations plus today's Financial Stability Report suggests it is a good time to assess where policymakers are at midsummer:
Spoiler Alert: As noted below, central banks and regulators in July reached DefCon1.
The MidSummer Situation -- Not Pretty
Infection transmission rates are increasing globally at an alarming rate, particularly in the United States. In the Northern Hemisphere, where it is currently midsummer, transmission rates hold particularly negative implications for economic as well as health trajectories for the winter when cold weather drives people indoors.
Additional economic stresses seem inevitable at this stage, particularly since a second wave of infections will coincide with crucial year-end decisions at companies. Firms will need to decide whether they remain open for 2021 or whether, instead, they will shutter their operations.
Some measure of financial stability has been engineered by regulators. Financial regulators have consistently provided time-limited leniency, extensions, and forbearance regarding whether and how credit assets assigned "non-performing" or "impaired status. While extensions are possible, the act of declaring insolvency forces a bank to declare a loss and, if the loan was collateralized, collect on the collateral.
Today's FSB Report suggests strongly that we will not have to wait until 4Q2020 to see banking system stress. The report makes clear that "credit quality is deteriorating while credit demand is rising." The words seem tame compared to the data, which they published:
The sharp V-shaped bounce in corporate ratings would seem reassuring if the pandemic situation were short-lived.
But the nearly vertical and consistent upward trend regarding loan demand in parallel shows a system experiencing significant distress because the vast majority of borrowers do not issue securities which receive external ratings. Moreover, the majority of lending in developed economies since March 2020 has benefited from a range of direct and indirect government guarantees.
Lending has continued to occur for two reasons. First, sovereigns have provided a range of backstops and credit support measures which effectively substitute their G7 sovereign credit rating for the credit rating that would otherwise attach to an individual borrower. Second, regulators have relaxed dramatically a broad range of regulatory standards and accounting requirements.
As the FSB noted today:
"The BCBS has emphasized that using capital resources to support the real economy and absorb losses should take priority at present, that the liquidity buffer helps banks absorb liquidity-related shocks, and maintain the flow of lending to the real economy, and that a measured drawdown of banks' Basel III buffers to meet this objectives is both anticipated and appropriate in the current period of stress."
The current period of stress. Let that sink in. The surge in credit demand does not indicate recovery. It illustrates deep need for funding to keep businesses afloat....and the funding has only been available due to extraordinary central bank support structures and extraordinary regulatory relaxations..
Now reflect on yesterday's announcement from France that they expect to see 800,000 to 1m people unemployed before year-end....or yesterday's European Union initiatives to pre-position "emergency joint procurements and strategic EU stockpiles of medical equipment...(and) influenza vaccines as well as create protocols "for the transport of medical personnel and patients between Member States and the coordination of the deployment of emergency medical teams and equipment to requesting countries through the EU Civil Protection Mechanism."
Any risk manager preparing scenario analyses and stress tests at midsummer must now ensure that portfolios are positioned for significant additional stress....even if the pandemic were magically to evaporate in the coming weeks (which is highly unlikely).
The Public Policy Trajectory -- DefCon 1
This week, central banks and financial regulators reached DefCon 1.
Yesterday, the Federal Reserve Bank of New York noted today that "term premiums do not appear to have come down significantly relative to just before the pandemic," despite asset purchases totaling $1.7tr in Treasuries and $800bn in mortgage-backed securities....so far this year.
Also yesterday, the Bank of Japan crossed the threshold into negative short-term interest rates (0.1%) while leaving long-term rates flat at 0%. Potentially more worrisome, they increased the thresholds for purchasing ETFs (to ¥12tr), REITS (to ¥ 180bn) and corporate bonds (to ¥ 7.5tr).
Throughout July, financial regulators in various jurisdictions have been quietly extending time-limited regulatory relaxations for asset valuations, permitting the banks to forego declaring losses until the autumn.
The Bank of Canada's Monetary Policy Report in the last 24 hours also observed point blank that "elevated indebtedness and economic uncertainty are expected to cause some businesses to scale back or cancel large investment projects."
Research from the Deutsche Bundesbank yesterday (Discussion Paper 35/2020) concludes that "overall, the estimates point to an elevated risk of a sovereign debt crisis" due to growing sovereign debt overhangs. It is true that German economists perpetually fret about debt overhangs. But this paper focuses on likely "fiscal space' available in light of the debt overhang, not the overhang itself. It makes for dour reading.
Finally, the Bank of England's external member of the Monetary Policy Committee (Silvana Tenreyo) delivered a sobering and meticulously researched speech that concluded "we are likely to see disinflationary pressures for quite some time." She based this conclusion not on the slightly better 2Q2020 GDP estimates (merely off -25% relative to 4Q2019) but on the likely economic impact of the summer pandemic resurgence in the United States together with an expected second wave of infections in the autumn. She drew from data generated by the last pandemic to make the case that current expectations concerning inflation are unrealistic:
So at midsummer, before the dreaded "second wave" of the pandemic arrives, policymakers have hit DefCon 1.