Fed Fails to Stem Market Bloodbath as Congress Stumbles on Aid Package
Economists say the sudden slowdown in economic activity from the coronavirus has no precedent in U.S. history.
A series of dramatic measures by the U.S. Federal Reserve failed to prevent another sharp downturn in the financial markets on Monday as traders reckoned with an abrupt stoppage in economic activity from the fast-spreading coronavirus that has no precedent in U.S. history, not even during the Great Depression.
“The descent from what was basically prosperity in 1929 to the depths of 1933 took four years to play out,” said Lawrence White, an economist at New York University. “This is a couple of weeks.”
Many economists, including some Fed officials, are estimating that quarantine and health effects from the novel coronavirus are already dramatically shrinking the U.S. economy, which could contract by as much as 50 percent in the second quarter. That figure comes from Federal Reserve Bank of St. Louis President James Bullard, who also said the U.S. unemployment rate could reach 30 percent in the same quarter, Bloomberg reported Sunday.
Most unnerving of all to the markets, perhaps, was that the rest of the federal government continued to squabble over an adequate response—Congress, in particular, failed again to agree Monday afternoon on the contours of a $2 trillion rescue package, with Democrats saying the current bill would amount to a corporate bailout with too little accountability and not enough money for the jobless and health care workers. Both sides engaged in shouting matches on the floor of the Senate, with Republican Senate Majority Leader Mitch McConnell declaring, to no avail, “The country is out of time.”
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Uncertainty reigned on the health front as well, with new indications that the United States is suffering one of the fastest increases in coronavirus cases worldwide while critical medical equipment is badly lacking. U.S. President Donald Trump, meanwhile, declined to take federal control of the production of more tests, masks, and other necessary items after invoking, but not fully implementing, the Defense Production Act last week.
Fears also arose that Trump, who has watched the stock market suddenly evaporate to levels lower than when he took office, is preparing to part ways with his health experts and try to reopen parts of the U.S. economy once the initial two-week quarantine period is ended, but before the virus is fully suppressed.
In a tweet on Sunday night, the president wrote in capital letters: “WE CANNOT LET THE CURE BE WORSE THAN THE PROBLEM ITSELF. AT THE END OF THE 15 DAY PERIOD, WE WILL MAKE A DECISION AS TO WHICH WAY WE WANT TO GO!” That idea was echoed by National Economic Council Director Larry Kudlow, who told CNBC on Monday: “At some point you have to ask yourself whether the shutdown is doing more harm than good.”
Earlier Monday, the U.S. Federal Reserve announced an open-ended plan to keep buying government debt and a first-ever plan to buy corporate debt to prevent large numbers of businesses from imploding. The Fed’s latest steps are a recognition that the traditional tools it used to avert catastrophe during the last big downturn are not sufficient to deal with the unprecedented shutdown of huge swaths of the economy all at once.
“It says this is a real crisis, and the Fed is going to do whatever it takes,” said Brad Setser, an expert on international economics at the Council on Foreign Relations.
But even the Fed’s latest moves, such as an effort to prop up the dangerously bloated corporate bond market, will do little to stem the broader damage as companies lay off workers by the hundreds of thousands; some forecasters expect to see a tenfold jump in monthly jobless claims, to more than 2 million.
In addition to expanding its traditional use of monetary stimulus, by pledging to keep buying U.S. Treasury bonds “in the amounts needed,” the Fed announced two new programs: a $300 billion financing plan and purchases of new and existing corporate bonds. Previously, the Federal Reserve had steered clear of corporate debt—but the magnitude of the threat from the overextended corporate sector, plus the immediate economic pain from the pandemic-related shutdown, makes intervention necessary.
“The significance of these programs is that it shows what the Fed can do under existing authorities,” like the so-called 13(3) provision, which allows it to have an impact on the broader economy by leveraging U.S. government cash to extend credit to businesses, Setser said.
“You need a mechanism for businesses to survive a three- or six-month slowdown,” he said, adding that he expects the initial $300 billion in new credit announced Monday and backstopped by the Treasury Department will be amped up in upcoming congressional legislation, which would offer more short-term relief to cash-strapped firms.
The cash crunch is especially urgent because corporate debt is at an all-time high, fueled by years of very low interest rates, which encouraged companies to pile on ever more obligations. The collapse of economic activity due first to the supply-side disruptions from the pandemic and later from the demand side as entire cities have gone into lockdown mode threatens to cut off cash flow for all kinds of businesses that need steady revenues to make their debt payments. Many forecasters, such as Fitch Ratings, already flagged corporate debt as a ticking time bomb late last year, warning that any big economic shock could lead to a wave of downgrades, defaults, and cascading damage to the broader economy.
Since the scope of the pandemic has become clear this month, corporate bonds have nosedived. Indices like the Standard & Poor’s Dow Jones bond indices showed a 12 percent decline in bonds of big companies, even nonfinancial firms, and especially in the energy sector, which has gone down by nearly one-quarter since the beginning of the month. Many U.S. energy firms, especially in the oil and gas business, are triply vulnerable right now. Most of them gorged on debt to fund operations and push U.S. oil production to record levels, despite poor returns, and many have poor ratings; they are suffering a historic decline in demand for oil as the global economy slams on the brakes; and they are the collateral damage of an oil-price war between Saudi Arabia and Russia that has driven down the price of crude more than 50 percent in a matter of weeks.
While the energy sector makes up a tiny slice of the corporate debt market, it reflects two important trends that have created such a dangerous situation—and that show why the Fed’s measures may be of only limited impact. First, corporate borrowing since the 2008 financial crisis has been at record-setting levels. Globally, nonfinancial corporate debt exploded from about $48 trillion in 2009 to $75 trillion at the end of last year. In the United States, companies also binged on cheap money, accumulating a record $10 trillion corporate debt. Much of that was used not to expand productive capacities, but for share buybacks to boost shareholder and executive compensation.
Second, the quality of that mountain of corporate debt is getting worse: About half of the “investment-grade” corporate debt in the United States and Europe is actually the lowest-possible rating in “investment grade.” That means a huge chunk of supposedly safe corporate debt is one downgrade away from essentially being junk—which many big institutional investors cannot hold in their portfolios, which means they’ll be forced to unload. In other words, the corporate debt market could soon turn into one giant junk bond bazaar.
The Federal Reserve’s actions Monday include support for “highly rated” corporate bonds—but not all of them. The companies most at risk of seeing cash flows seize up, defaulting on debt, and laying off workers are precisely those that weren’t highly rated or that resorted to high-interest leveraged loans. That will likely limit the practical impact of the Fed’s measures in the corporate bond market.
Keith Johnson is a senior staff writer at Foreign Policy. Twitter: @KFJ_FP
Michael Hirsh is a senior correspondent and deputy news editor at Foreign Policy. Twitter: @michaelphirsh