The global economy looked into the abyss on March 16, 2020. COVID-19 had sent country after country into lockdown, disrupting manufacturing and services supply chains. Global US dollar liquidity had dried up and recession risks were increasing. In Europe, credit default swaps were traded on firms with a probability of default of around 38%. As Confirmed COVID-19 cases rose to just about 165,000 from fewer than 10 in JanuaryScientists frantically speculated about deaths and transmission rates.
Meanwhile, market participants were on tenterhooks. As the mood turned from concern to panic, the crash began. The Dow Jones ended the day down almost 3,000 points. The S&P 500 fell 12% and the NASDAQ fell 12.3%. It was the Worst day for the US stock markets since Black Monday 1987.
The Federal Reserve revisited its approach to the worldwide financial crisis, attempting to calm markets by expanding immediate liquidity to forestall a pandemic-related cross-market domino effect. Before the market opened on March 16, 2020, the Fed agreed swap line arrangements with five other central banks to ease the strain on global credit supply. Just a few days later, the Fed declared have made similar agreements with nine other central banks.
But it wasn’t enough. Before the top of March, the Fed will… expanded its provisions resulting in much more central banks holding US government bonds, including Saudi Arabia. These central banks could temporarily swap their securities held on the Fed to achieve access to immediate U.S. dollar funding, in order that they wouldn’t must liquidate their Treasury securities.
Liquidity support for US dollar borrowers will at all times be an option for the Fed. Such interventions show that the central bank is committed to addressing concerns about economic instability and protecting the economy from bankruptcy. Short term.
But what in regards to the long run? Does such rapid – and infrequently predictable – motion increase the vulnerability of the economic system? Does it pose an ethical hazard for central banks and market participants?
It is significant what state an economy is in when a crisis occurs. Thanks to stricter regulation and the evolving Basel Accords, banks at the moment are more resilient and higher capitalized than before the worldwide financial crisis. They will not be the major concern. But the economy has more debt and is much more vulnerable to shocks. In 2020, total global debt rose at a pace not seen since World War II resulting from massive monetary stimulus. By the top of 2021, global debt had reached a worth A record $303 trillion.
This excessive leverage has created greater systemic risk, particularly given the recent rise in rates of interest. During the simple money era, businesses rushed to borrow. Confident that policymakers would intervene in turbulent times, they failed to ascertain a margin of safety.
The recent market volatility – the brutal confrontations between bulls and bears – has been sparked by speculation about what the Fed will do next. The back-and-forth has been repeated over and over this 12 months: Bad economic news sends bulls rushing to smaller rate of interest hikes in anticipation of a possible Fed reversal, while strong GDP growth or employment numbers fuel bears and increase the likelihood that the Fed will take motion Course holds weapons. Now, because the December Federal Open Market Committee (FOMC) meeting approaches, stock markets have found renewed traction on high hopes for a turnaround.
The Fed first raised rates of interest last March, so the present rate hike cycle is lower than a 12 months old. But indebted firms are already under pressure. How many more hikes can they handle and for the way long? Preventing runaway inflation is crucial, but so is managing the inevitable consequences through rigorously crafted fiscal policies that take the whole economy under consideration.
As investment professionals, we must anticipate the long-term challenge. Today, the threat is obvious: the upper rate of interest environment will endanger heavily financially leveraged firms. This implies that risk management should be amongst our top priorities and we must hedge the speed hike cycle. For energetic asset liability management, we’d like to look beyond the accounting implications and focus, amongst other things, on the economic value of equity.
The bottom line is that within the midst of economic turmoil, resolving the immediate threat often brings with it greater long-term dangers. We should avoid speculating about when or if central banks or regulators will intervene. We must also keep in mind that just as there are unique causes for each economic downturn, there are also unique cures.
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Image courtesy of the Federal Reserve
