“We’re Going to Need a Bigger Boat”

Published on: March 28th, 2020

In this month’s Deep Dive, Julian discusses how CV19 required enormous triage by the Fed to prevent what amounted to a ‘bank run’ from bringing down the global financial system. The Fed’s work is not yet done, even though the response has already been unprecedented. Julian walks you through recent events and offers some guidance as to where the longer-term may take us.

Comments

  • MC
    Mathieu C.
    1 April 2020 @ 17:43
    Julian, I am wondering if you could step back a little with regards to these FX swaps/forward and detailed a little bit what is happening maybe in a next deep dive or focus. I found this paper interesting, however a little difficult to understand in my opinion for someone with no background in these markets. "On the demand side, institutional investors[...] have obligations in domestic currency, but they hold a globally diversified portfolio, with a substantial portion denominated in the US dollar. To finance the purchase of dollar assets, they swap domestic currency into dollars, thereby gaining access to dollar funding on a currency-hedged basis. Their portfolios have grown substantially since the GFC, giving rise to greater hedging needs. " if the demand for dollar funding is an hedge why do they require sill more dollars? Isn't it fixed/traded at inception? Are they borrowing short term to finance a "globally diversified portfolio" (it doesnt make much sense to me) https://www.bis.org/publ/bisbull01.pdf
    • HM
      Harry M. | Real Vision
      1 April 2020 @ 19:18
      Hi Mathieu. So they dont need more dollars, they just need the dollars they were borrowing to buy the assets they were carrying. Let me give you an example. You are a Singapore based structured credit manager, and you have been buying US CLO tranches as part of your funds holdings. However your fund is SGD based, and the assets are USD. So you can either sell SGB to buy USD and take the fx risks in your fund, or you can do an FX swap. Here you contact a dealer who sells you dollars spot, and buys them back from you in 1 months time. So now you have dollars for the next month, to fund your CLO $ assets, but you dont have a dollar exposure cos you have both bought and sold the dollars. You bought them spot and sold them forward. However one night, you come to work to "roll" your dollar fx swap for another month, and the bank says "sorry - we cant do it. Can you try another bank?" You try 5 banks and realize none of them will do it. So now you are in a pickle. If you do not borrow some dollars your custodial will tell you that you are short dollars and will buy them to hedge your position. But if that happens you will be taking fx risk on your CLO bonds, which you didnt originally want to do. Does that help explain?
    • MC
      Mathieu C.
      2 April 2020 @ 02:49
      Hi Harry, it helped a lot. Much appreciated.
  • RH
    Rob H.
    29 March 2020 @ 16:53
    Hi Julian, great insights in your report as usual. I got an interesting letter this week from the Department of Insurance of Ca. Basically they are ordering the Insurance Data on Business Interruption Coverage to Assist Ca Small Businesses on the COVID-19 losses. The fact is all major carriers have excluded communicable diseases so most think the Insurance companies are off the hook and won't suffer major losses. I'm thinking when the states start to review this data and find out that almost all the major insurance carriers are going to deny these BI claims they are going to have some serious issues with this. This is also going to add to the public outcry on the denial of these claims. I would think we could see the states pass legislation to make insurance companies pay a portion of these claims. If this happens across the country I would also think it would make insurance companies forced sellers of some of their investment holdings. Do you have any thoughts on this? Below is a paragraph from the letter. “The coronavirus crisis is devastating small businesses across our state, throwing people out of work and quickly unraveling our economy,” Commissioner Lara said. “Although many small businesses maintain commercial multi-peril insurance policies with business interruption coverage, they will have large uninsured losses. We are currently working with the insurance industry and business groups to find creative solutions during this unprecedented crisis to make sure our businesses survive, and we need this data to define the size of the problem.”
    • HM
      Harry M. | Real Vision
      29 March 2020 @ 18:40
      So, I will try and answer on Julian's behalf and if he wants to correct or revise my answer Im sure he will. First of all thanks for the color, and its a great point. I would guess that there will need to be some kind of government assistance, either in asserting that insurance companies are liable, or direct payments from the government to small business owners to take the place of business interruption coverage. My guess is the latter rather than the former, because bankrupting the insurance companies wont really help, and besides, insurance will just try and claw it back in higher policy rates immediately after. But as you correctly note, if they are forced to pay, it will create more selling pressure in global markets. Perfectly possible you get a hybrid response, where government reaches some kind of agreement with the insurance companies to implement a retrospective insurance cover which is refunded by the government. But State governments have such limited resources that it would have to be at Federal level. The only stick the States have is that insurance is regulated at the State level.
    • RH
      Rob H.
      29 March 2020 @ 23:52
      Hi Harry, thanks for the reply. I agree I wouldn’t expect the government to BK the insurance companies. Yet, I could see them ask them to pay a potion of the loses since we are all in this together.
    • JB
      Julian B. | Contributor
      31 March 2020 @ 22:47
      I agree with Harry's take. But there's a bigger issue. I've said for the record, that the reign of laissez-faire markets unleashed by Reagan and Thatcher in the late 80's peaked in 2008. This marks the next chapter. When governments start to decide who wins and looses, you aren't far from a command economy. FYI we could see the same in the CMBS market, where government may prevent investors moving to seize assets from borrowers who have fallen short of covenants in their deals. I'm sure the fact, that our President is a developer will ensure this is the way we go! Bottom line, very bad for markets and the economy.
  • km
    kenneth m.
    30 March 2020 @ 01:58
    I am sure that none of us want to clog up the board with our thanks. But this kind of clear thinking/writing is more appreciated than many of us can express. I am a seasoned investor and certainly do not feel helpless - but this is insight that only a true Professional can provide and it makes a big difference. As Julian said before, there is nothing wrong with cash, right now. Or, as Will Rogers once said during the 1930's "I am not as concerned about the return ON my money as I am the return OF my money".
    • JB
      Julian B. | Contributor
      31 March 2020 @ 22:36
      Cheers Kenneth! But at some point, we will have to find you something to put that cash into!
  • JM
    Jake M.
    30 March 2020 @ 19:50
    For those of you RV PRO members who trade on dollar bull thesis, what's your take on the following counter-argument? https://twitter.com/LynAldenContact/status/1244640648071974912 I think it's interesting side to look at, basically saying while there's huge dollar debt, foreign entities also hold huge dollar assets as well. So the dollar shortage problem can be mitigated by selling dollar assets. If dollar bull thesis still true, then what's the incentive for foreign entities NOT to sell dollar assets?
    • DM
      Davis M.
      31 March 2020 @ 11:56
      I really enjoyed her analysis as well. Her comparison between the 1930 and now were very solid and made alot of sense to me. While the policy responses may be the same, the impact of them will be dramatically different due to differences in creditor/debtor nation, hard/fiat money, consumer savings/consumer debt, and other key differences. Unlike the 1930 where it was a deflationary impact, this time it will be an inflationary one. I think most will agree long term there will need to be a weaker dollar. The debate is how we get there. I am in the camp a strong dollar is going to drive this monetary reset. While the FED have had their "do whatever it takes" moment, I do not believe they can really do "infinite" printing. They know this will cause a loss of "confidence" in the dollar and then it is really game over. Just read Norway's wealth fund will start selling assets for USD to provide stimulus for economy and coronavirus efforts. This creates a greater demand for USD compared to holding the assets. Other nations will need to do the same. Personally, I am spending less and saving more due to current situation. Isn't this taking USD out of circulation and hence supply? I think on "Any Given Sunday" there is going to be a Plaza Accord type event where the USD is devalued. I am watching for actions which indicate this is getting closer and don't think we are there yet. Full disclosure - I am holding alot of precious metals and miners in the event the Reset happens and while I will lose on the dollar trade, i will more than make up for it with this hedge.
    • JB
      Julian B. | Contributor
      31 March 2020 @ 22:34
      See my comments above. A loss of faith in the US driven by out of control unemployment could lead to a $ collapse. PS The reason the Fed opened repo lines to foreign CBs is to prevent them selling US Treasuries. Lets see if it works.
  • TC
    Thomas C.
    30 March 2020 @ 22:25
    Really excellent analysis Julian. Lots to think about but you have covered the lot and provided excellent tech background. My immediate takeaway is the fed needs to maneuver a deleveraging (perhaps over a longer period) to bring things back together with YCC.
    • JB
      Julian B. | Contributor
      31 March 2020 @ 22:32
      Yes Thomas. The only hope is they get ahead of this deleveraging cycle and prevent a deflationary, depressionary bust. They are trying hard but the task is monumental
  • DW
    Derek W.
    31 March 2020 @ 01:32
    slightly off topic, but the question that keeps rattling around in my head is- How does an economy start back up after a projected unemployment rate of 34%? Is there anything in history that might show us what it looks like?
    • DR
      Derrick R.
      31 March 2020 @ 02:50
      This is a great question.
    • JL
      Jack L.
      31 March 2020 @ 04:05
      In the 1930's the US (federal) Works Progress Administration employed around 3.5 million people at peak. Building roads, bridges, & more. https://en.wikipedia.org/wiki/Works_Progress_Administration
    • HM
      Harry M. | Real Vision
      31 March 2020 @ 11:00
      A great question and I am very concerned too. I note that the UK is subsidizing employment for companies at the moment, to the tune of 80% of wage costs. I would not be surprised to see something like that as a possible approach here.
    • SA
      Saad A.
      31 March 2020 @ 19:38
      It will have to be some sort of a massive infra program. Which may make sense cuz it seems the bond market is dead at least for the next few years and pension funds will need those infra projects for investments to get some sort return. Ad of course the byproduct is jobs... Lots of jobs. It will have to be really BIg infa program. The problem is these infra projects will need to be structured as 3P and the tendering process takes time, at least 16 months
    • JB
      Julian B. | Contributor
      31 March 2020 @ 22:30
      That's the one question that keeps me awake at night. Bottom line, the solution would be infrastructure spending but that is impossible to roll out quickly. Hence, Harry's comment about direct wage subsidies. PS. I think scenario, is why Trump want us to go back to work soon. But that is easier said than done. Would you take your kids on a plane in a month just because the President says its safe? I'll be honest, if we get anywhere close to 20-30% unemployment (I don't have that in my models yet) I think the US could implode. This isn't the 1930's where we line up for soup in our best suit. It will be chaos. If foreign investors lose faith in the US they'll sell stocks, bonds and the USD. I think this outcome is a 20 delta at this stage.
  • WM
    Will M.
    28 March 2020 @ 20:27
    Interesting narrative on the financial plumbing which of course leads to..... does this change the ownership or timing of ownership of RVT recon for TLT and UUP. I am increasingly feeling that this 2020 financial chaos is going to lead to worse outcomes than the 2008 crisis and feel biased toward precious metal stocks as they may be one of the few industries that will generate big profits in 2020.
    • HM
      Harry M. | Real Vision
      28 March 2020 @ 20:33
      So if money is getting to the right place, it probably doesnt change the TLT call. Simply cos there is no less pressure to sell USTs to free up liquidity. However it might offset some of the dollar bullish arguments if there is no pressure FX swaps cos the Fed stepped in. That said, in 2008, the scale of losses meant that foreign banks and investors had to buy a lot of dollars to close out their funded dollar investments. Im not sure we have seen those types of flows yet.
    • JM
      Jake M.
      28 March 2020 @ 20:42
      I suppose for TLT, the main argument is that the FED will keep buying it to support other asset prices, and to Raoul's point, he thinks FED has to buy a lot more given the scale of problem we have.
    • BS
      Bevyn S.
      28 March 2020 @ 21:28
      I'm pretty fired up about miners too... Hard to pick a bottom though!
    • AT
      Andy T.
      28 March 2020 @ 21:53
      Gold miners do not correlate to gold
    • CH
      Charlie H.
      28 March 2020 @ 23:56
      Gold miners are stocks too. It will get liquidated if the equities market does.
    • MJ
      Matthew J.
      31 March 2020 @ 09:05
      Thanks for the question and thoughts on foreign bank US investments. Regarding Gold and Miners, I am also trying to consider the positions I'd like to take going ahead and how they may play out in return and time scale. Following on from Andrew T. regarding miners, I read that their stock may be kept down initially due to shutdowns and the real world disruption to work & transportation, this is specific to this crisis of course. So there would be a delay in the miners stock price as they need time to get operations up and running again. Any thoughts? I am also interested in people opinions for if futures would be the best initial place to speculate when the time is right, we already have a premium on physical and I believe also an increase margin requirement for GC and SI futures. ETFs I'm not so sure on. All suggestions welcome
  • HK
    Hendrik K.
    28 March 2020 @ 18:52
    Interesting thesis - question from my perspective what to do now from a personal perspective to protect wealth.
    • HM
      Harry M. | Real Vision
      28 March 2020 @ 20:05
      In the long, long run? Real assets with fixed rate funding. But we have a way to go before we make it to the long run. First we need to see the liquidity position stabilize (which now does seem to be happening - this piece is based on a piece written a week ago). Interesting to see funding normalizing in a number of key markets. However take a bit of care when the tbill issuance starts again. Right now Tbills are trading quite expensive cos we had a flight to quality and issuance has been paused. When it starts again that issuance will give people more choice on short funding. Worth noting that cos they moved the tax year back, the demand for funding will peak later than usual. Not impossible to see a problem if the issuance of Tbill restarts around the time the delayed tax payments are due. In the meantime on the one hand it seems like there are a lot of cheap assets that the Fed is all but guaranteeing. And on the other hand, we haven't addressed the question of who is gonna bear the rather substantial losses from the economic hiatus. For me, that points to cheap credit type instruments that the Fed has promised to either fund or buy. As usual, this is not investment advice.
    • RK
      Robert K.
      29 March 2020 @ 10:22
      "The central bank will, for the first time, buy up to 20% of the assets of U.S.-listed exchange-traded funds that provide broad exposure to investment-grade bonds." https://www.barrons.com/articles/why-the-federal-reserve-is-buying-bond-etfs-51585353014
    • HK
      Hendrik K.
      30 March 2020 @ 14:08
      thanks for the detailed Feedback!
  • DP
    Dimple P.
    29 March 2020 @ 03:28
    Thank you Julian. Do you think that we are likely to see some central bank gold liquidation in places where the fed has not extended swap lines? Seems like an easy fix to alleviate short term dollar squeeze in EM countries. Just pondering on all of the longer term knock-on effects of global dollar shortage.
    • HM
      Harry M. | Real Vision
      29 March 2020 @ 12:39
      I asked JB and it seems quite unlikely although he cant rule it out. More likely that the Fed extends lines to those areas as peer CBs ask them to. Really, the support here is for foreign banks, not foreign central banks.
    • DP
      Dimple P.
      29 March 2020 @ 22:49
      Thank you @Harry M.
  • JM
    Jake M.
    28 March 2020 @ 20:18
    Hi Julian/Raoul (or any one else who knows better than me), asking as a nooby person who has limited experience in FX. Raoul's thesis is that dollar will become stronger as world trade plunges and offshore dollar debt still needs to be served. But if dollar does get stronger, wouldn't it weaken again because dollar strength is an opportunity for foreign banks to make money in their currency as they have (unlimited?) swap line with FED? for an extreme example, if I am a bank in Europe, and I see 1 dollar equates say 100 euros in FX market, and say through swap via ECB I can get 1 dollar for every 2 euros, doesn't that look like an immense opportunity to make 50x in euros?
    • HM
      Harry M. | Real Vision
      28 March 2020 @ 20:28
      I wouldn't think about it like that. Banks dont like taking unlimited amounts of risk. A little is fine. Big naked bets on fx with no "edge" is not fine. The swap line doesnt give you free dollars. It just makes it possible to borrow dollars by using non-dollar collateral for Eurozone banks with the ECB. So a better analogy is imagine you borrowed money to buy a house, and all of a sudden the bank sends you a note saying, "actually we would like you to pay that money back in 1 week". Now you are running around looking for another bank to lend you money. This analogy is by no means perfect either.
    • JM
      Jake M.
      28 March 2020 @ 20:46
      thanks Harry. It seems then it all comes down to risk the banks are willing to take. Is there some kind of metric that is a good proxy showing how much risk the euro bank is willing to take for dollar loan over time?
    • HM
      Harry M. | Real Vision
      29 March 2020 @ 21:35
      Yeah, the $/Euro basis swap is probably the best proxy. But that might be quite hard to see without access to specialist feeds. Dont know how to find the cross currency basis except on bloomberg or reuters. I will ask around
  • J
    Jim .
    29 March 2020 @ 01:50
    Julian, as always thought provoking, but I am going to play devil’s advocate for a minute. The Fed, OCC and FDIC along with FASB are already rolling back regulations and accounting standards to the benefit of the banks. Would you mind being more specific with respect to the regulations from the GFC that you are referencing here and pardon my skepticism, but Jamie Dimon told us that JPM had the liquidity to preempt or at a minimum ameliorate the repo crisis back in September but he pretty much stated that JPM would not lend its liquidity as it wanted regulatory relief. The cynic in me cannot help but question the fact that the Fed is owned by the banks (a conflict in and of itself as their regulator) it seemed like Powell and the Fed wanted to cut rates/ do QE (as the Fed went from being a hostage of the stock market to the guardian of the stock market of their own volition) while Not wanting to be seen as giving in to Trump as it became apparent that earnings were not going to grow into the multiples of 2019 and the repo crisis became a convenient excuse for the Fed and the banks who wanted regulatory relief to both get what they wanted. It was working until the Coronavirus came along and as always the black swan exposed the fact that the risk markets (equity and credit) were priced for perfection and now the Fed is going to do even more to keep the “Everything Bubble” from causing too much damage. But when will the Fed get some humility and figure out that the cure causes a worse disease that may ultimately lead the US down a path of socialism? Apologies for the rant but I am concerned about where we end up from the Fed’s unmitigated disaster of the “Liquidity is the Answer to All of Our Problems” playbook started by Greenspan on 10/19/87?
    • AS
      Amit S.
      29 March 2020 @ 03:51
      Wish I could like twice - for the last line in your comment. Reagan and Greenspan were the real architects of the mess we experienced in the late 90's, '08 and experiencing now. Bernanke just helped push it along - he is/was no Hero. History, I presume, will be kinder to Yellen.
    • HM
      Harry M. | Real Vision
      29 March 2020 @ 13:07
      Forgive me for answering for JB, but when he sees this he may choose to correct if I have any of this wrong. The living will rules require that bank should be able to operate for 30 days without accessing money markets. Leverage ratio rules limit total leverage. So providing additional repo would not save a bank which had already maxed out on its leverage ratio limit. Personally I was particularly "amused" by the language the Fed used when 8 banks were persuaded to access the discount window simultaneously to break down any "stigma". I couldn't help but ask myself, whether any of the 8, would have been stigmatized if they hadn't persuaded others to join in. My completely uninformed guess is that at least 1 bank who borrowed from the window, found discount window funding very useful provided it was protected by anonymity. I would argue 1 is logically a minimum not a maximum. Once again, I have no information on this subject, other than seeing where Tbills traded. I'm sure all US banks were and are completely healthy. I completely agree with your other comments. I do not know when the Fed will get some humility. Probably when economists realize they don't know anything about banking and very little about the economy. I share your concerns about where we will end up.
  • JM
    John M.
    29 March 2020 @ 05:38
    Great report Julian. In your last flash update, you recommended looking at high quality MBS REITS such as ARR and EARN which got a nice bump last week, however in this report it seems you are concerned MBS will struggle. Given the bounce in these higher quality REITS, would you recommend dipping a toe into these high quality options?
    • HM
      Harry M. | Real Vision
      29 March 2020 @ 12:53
      I think its a contingent thing. First of all non of this constitutes investment advice, because offering investment advice would be against the law in the US. Secondly, lets distinguish between Agency and non-Agency MBS. If the Fed provides QE support to the Agency MBS market, then MBS REITS are very cheap. And its very hard to imagine that that support isn't coming. Agency MBS is already good collateral with the Fed. The only question is whether they are prepared to buy it like in 2008.f Without Fed support Agency MBS will correct, only slower, and it will cost the REITs more to delevr. JB thinks they will, and reasonable soon. Now some MBS REITS had very little locked-in finance, and others carried very significant non-Agency and non-conforming CMBS. Both strategies look very dicey right now, unless the Fed widens its support. I would imagine the market had a good idea of which which MBS REITS were like this, and marked them down. So as a first pass, the funds which outperformed on the way down are probably the safest. But if you do a little reading its probably obvious which are the least exposed. I very much doubt this collateral will be trading very cheap in 6 months. I would also say that it looks like many funds are trading at very significant discounts to NAV. They have too much leverage but it should be possible to pay 60c for $1.
  • MP
    Matthew P.
    28 March 2020 @ 20:43
    Summary: had crisis, got stimulus merge of fed+treasury...more, including yield curve control coming... A playbook to profit from some of these potential foresights would be useful! Thanks for the thoughts
    • HM
      Harry M. | Real Vision
      28 March 2020 @ 20:58
      Im sure one is coming. But will relay to Julian.
    • BS
      Bevyn S.
      28 March 2020 @ 21:14
      *cough* buy gold *cough* Of course after we pass this de-leveraging black hole
    • AT
      Andy T.
      28 March 2020 @ 21:51
      Recent run up in gold says wait a while IMO.
    • RK
      Robert K.
      29 March 2020 @ 10:05
      Yes, and ultimately suggestions by Julian to the question asked in the report: "which markets will benefit from the warm embrace of the Fed and which will be left in the cold, at least for now? "
    • RK
      Robert K.
      29 March 2020 @ 10:24
      Some hints here: "The central bank will, for the first time, buy up to 20% of the assets of U.S.-listed exchange-traded funds that provide broad exposure to investment-grade bonds." https://www.barrons.com/articles/why-the-federal-reserve-is-buying-bond-etfs-51585353014
  • JG
    Johan G.
    28 March 2020 @ 20:20
    Fascinating! Lots of problems with the present financial plumbing! The way I see the big picture is that there are to many financial claims on the real economy, leverage is to high after all the QE. In such environment the interest rate must be kept near zero, and volatility suppressed for the system to work. It then becomes increasingly difficult to provide acceptable collateral at many levels of the financial system. A black swan that reduces the growth of the real economy causes a fall in confidence, lack of collateral, increase in volatility, and the velocity of money drops and liquidity freezes up. To solve it the Fed needs to do more QE which increases the leverage in the economy even more. When we come out of this Covid-19 downturn, it will no longer be possible to sustain a financial system as we have been used to, it will be taken over by government/fed and tightly regulated to serve the real economy, but lots of pain and change of hands of wealth before that. Or we go one more round, Mnuchin saves Wall Street and not Main Street; who knows.
    • HM
      Harry M. | Real Vision
      28 March 2020 @ 20:30
      Exactly so Johan. Seems like you and Julian have rather similar views.
    • WS
      Winslow S.
      28 March 2020 @ 20:49
      How does the Fed doing QE increase leverage? In QE they buy assets in exchange for new $. Doesn't that by definition lower leverage?
    • HM
      Harry M. | Real Vision
      28 March 2020 @ 21:11
      I would argue the QE does not mechanically increase leverage but it does serve as a protective put option for those asset prices. QE underwrites risky assets, making it safer to have high levels of leverage.
    • JG
      Johan G.
      28 March 2020 @ 21:39
      Exactly Harry! QE keeps interest rates artificially low and inflates asset values, so everybody feels wealthy, and more debt can be created, but if your wealth depends on zero interest rates, the system is fragile. In the mean time more debt does not increase the production of the real economy anymore(Carmen,Reinhardt)
  • BS
    Bevyn S.
    28 March 2020 @ 21:20
    Love it Julian...! Totally agree with the conclusion. Just don't see any other way out of this. The breaking of supply chains and de-globalization trend will only and fuel to the fire via cost push inflation. Can't help but think this will lead to high volatility across asset classes for several years...