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Credit markets signal the US risks heading towards a financial crisis

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Key Points
  • Markets are looking to the Federal Reserve, other regulators and Congress to keep the coronavirus pandemic from creating a financial crisis in addition to an economic downturn.
  • After a blast of stimulus over the weekend, the Fed on Tuesday said it would create a facility to help the corporate paper market.
  • Treasury Secretary Steven Mnuchin said he was talking to the Senate on Tuesday about a big package of stimulus, including help for airlines and cash for individuals.
  • "What sets off a financial crisis is when firms are unable to get cash," said one economist. "So far it doesn't seem that happened, but that's the risk. That's why the Fed is trying to flood the pipelines with liquidity."
A trader stands outside the New York Stock Exchange (NYSE) in New York, U.S., on Monday, March 16, 2020.
Gabriela Bhaskas | Bloomberg | Getty Images

The swift hit to the U.S. economy from efforts to stop the spread of the coronavirus has created a crunch in credit markets that threatens to turn an economic downturn into a financial crisis.

Companies have rushed to raise cash by drawing down credit lines and other borrowing, as they face a sudden shortfall in revenues. The ripple effect has been a whammy to credit markets, sending many spreads wider across the markets and even stalling out the commercial paper market, where the highest rated companies go for cash. 

"We're speeding towards one. We need to deal with this. This is real now. All the red flags are raised," said Diane Swonk, chief economist at Grant Thornton. 

The Federal Reserve on Tuesday said it would provide help to companies having a hard time getting the short-term funding they need.  At a White House briefing, Treasury Secretary Steven Mnuchin also said he would speak with the Senate on Tuesday about a big stimulus package, including help for airlines and a program to give cash to individuals.

The Fed announcement and Mnuchin's comments helped send stocks higher. The Dow was up nearly 3% Tuesday after losing more than 12% Monday, in its worst trading day since 1987. The iShares iBoxx $ High Yield Corporate Bond ETF, HYG, a proxy for the junk bond market, turned higher after the Fed announcement and signaled some easing in high-yield.

"It's helping the short-term commercial paper side and things are trading a little better in high yield," said Peter Boockvar, chief investment strategist at Bleakley Advisory Group. "They're buying time " until the pace of new cases of coronavirus slows.

The Fed, as expected, announced a special credit facility to purchase paper from issuers that have been having a hard time finding buyers in the open market. The Fed took the action for the one-day facility under its emergency 13 (3) powers of he Federal Reserve Act and it will involve three month paper for companies.

"It's a piece of the puzzle, but we need more pieces of the puzzle to fall in place and they all start on Capitol Hill," said Ward McCarthy, chief financial economist at Jefferies.

John Briggs, head of strategy at NatWest Markets, said there was some easing in commercial paper but credit markets  were still "gummy." 

"Mnuchin got stocks on a roll and he made some promises here. Hopefully, he'll get some agreement," said Briggs. "I'm glad that fiscal is getting moving." 

Briggs said he's also watching a $3.5 billion Verizon debt offering, which could be one of the first offerings in days. "Can they price it? Where can they price it, and what kind of demand is there? I'm going to watch it. It's a good sign the leads [bankers] think they're going to be able to do it," he said. 

Pepsi and ExxonMobil were also looking to issue debt. "It's a crack opening. Hopefully others can follow," said Boockvar.

Since last week, credit markets have malfunctioned, starting with a mispricing and lack of liquidity in the Treasury market. The Fed has taken out its heavy artillery - slashing interest rates to zero, flooding the market with liquidity and creating a big new $700 billion quantitative easing program to buy Treasurys and mortgage securities. On Tuesday, the Fed announced another $500 billion operation for repo funding markets, as it did Monday.

"We're at the early stages, and we need to do everything we can to stop it from compounding. The Fed is now encouraging banks to lend … trying to make it easier for them to bridge us. We need to stay solvent," said Swonk. "That's the key in a health crisis. We need to stay solvent as we come to a standstill … cash flows are drying up overnight." 

Market pros are looking for the Fed to try new strategies it has not used in the past. The Fed has also extended swap lines, as investors globally look for dollars to meet dollar funding needs. The dollar was up nearly 1.8% against the euro and 1.5% against the yen. 

"The impact of funding strains and the frozen commercial paper market is seen in the very front end of the [investment grade] corporate bond market as spread curves are inverted," noted Bank of America strategists in a morning note Tuesday. "While normally spread cures invert due to credit risk, this time it is a liquidity story as investors raise cash and money market and other funds de-risk as they expect large withdrawals given the partial shut down of the global economy." 

BofA said among companies that recently announced they would draw on credit lines include Micron Technology, Anheuser-Busch InBev, Kraft Heinz, Park Hotels, Carnival Corp. and Caesars Entertainment.

The Fed's new facility should help, but strategists have been saying there needs to be more action. Credit spreads continued to widen early Tuesday on a whole range of securities, including junk bonds, high grade credits and muni bonds.

"Junk bonds and high yield debt are particularly worrisome," said Swonk. "We just can't afford to let those types of failures happen now. We need to put political ideology aside." 

Regulators are also considering whether to relax liquidity rules on the nation's banks to help ease pressure on them. One concern in markets for months now has been that the government hurt liquidity with stricter rules on leveraged lending and bank balance sheets since the financial crisis.

Briggs said the Fed's programs have helped the problems in the Treasury market, but elsewhere in credit, the stress is still there. 

"The Fed fixed the Treasury functioning. For the most part, Treasury functioning is better, but credit market functioning is not there," he said. 

Briggs said it appears investors are hedging their cash positions with indexes and credit default swaps. "That sounds like 2008 type things," he said. "I have a hard time thinking equity markets are going to rally unless credit markets get healthier."

He said he is now watching to see how much the Fed's facility will help commercial paper. "If you have problems in the 30-to-90 day market, 30-year credit is going to struggle," he said.

Compounding the problems in commercial paper is the fact that money markets are being tapped for cash by investors, and money markets are big buyers of commercial paper.

Economists have been downgrading their view of the economy, and many now see a recession from the impact of the shutdown of activity. The result has been restaurants and small businesses closing in some states, workers working from home across the U.S. and the shutdown of the college campuses and schools.

"What sets off a financial crisis is when firms are unable to get cash," said McCarthy. "So far it doesn't seem that happened, but that's the risk. That's why the Fed is trying to flood the pipelines with liquidity, encouraging banks to use the discount window and pushing swaps facilities again. They are doing everything to prevent this from becoming a financial crisis."

The Fed has been taking aim at the short-term funding market since September, when there was a sudden spike in overnight rates due to a lack of liquidity. Since last week, the Fed has double-barreled additional liquidity for that market, where banks go to fund themselves.

"This really is the litmus test now. The virus is not a permanent threat to the economy. It will devastate the second quarter, but then the economy is likely to recover. What is a significant threat is that the virus starts an all-out financial crisis. If that happens full blown recession is unavoidable," said McCarthy.