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Central banks: Ready for the second wave?

Prices of risk assets have rallied strongly in spite of extremely uncertain economic conditions. There are good reasons for this bounce-back from the lows recorded in March – unprecedented action by the central banks was a key factor. What further options do the central banks have at their disposal?

Investing profitably has become even more challenging as a result of the coronavirus crisis. Following the strong recovery, valuations in the equity markets are mostly very high. Spreads in the bond markets have also narrowed significantly. A key driver behind the recovery in risk asset prices is that safe government bonds no longer offer any real return. Since the Federal Reserve lowered its key interest rate to 0 per cent in March (Fed Funds Rate: 0.0–0.25 per cent), government bonds have ceased to yield real returns even in the US. In the eurozone, yields in core markets such as Germany, the Netherlands and France remain stubbornly in negative territory. Investors are therefore turning to financial products that still offer some return. Among these are corporate bonds, emerging market bonds and equities. Union Investment expects that this situation will persist for a prolonged period of time, as rapidly rising government debt levels in many countries will keep interest rates low.

Central banks respond with interest-rate cuts…

Central bank key interest rates in the US and the eurozone
Central banks respond with interest-rate cuts…
Source: Bloomberg, as at 30 June 2020.

While it is unclear at this stage whether there will be a second wave of coronavirus – the World Health Organisation is not excluding this possibility – leading central banks have indicated that they will do everything within their power to mitigate the impact of the crisis. In principle, the extent of the assurances they have already provided should be sufficient to keep the government and corporate bond markets supported (through asset purchase programmes) until well into 2021.

Take the European Central Bank (ECB) as an example: It acts as a large-scale buyer of bonds. Purchases of equities, such as those made by the Bank of Japan (BoJ) via exchange-traded funds (ETFs), are currently not part of its agenda. In light of the coronavirus crisis, the ECB has expanded its existing asset purchase programme (APP) by €120 billion and extended its duration to the end of 2020 as part of its quantitative easing (QE) measures. It is also taking a more flexible approach to the execution of its purchases. For example, the capital key that governs the bank’s bond purchases – the proportions are based on the member states’ respective equity stake in the ECB – can be relaxed. In addition, the new pandemic emergency purchase programme (PEPP) was increased to €1.35 trillion in June with a duration until mid-2021. Proceeds from maturities will continue to be reinvested at least until the end of 2022. And the ECB has not ruled out the possibility of expanding the PEPP even further if circumstances require. As at 10 July, the ECB was holding bonds with an aggregate value of €383.2 billion under the PEPP. Since quantitative easing measures were implemented, holdings under the APP have increased to €2,253 billion in government bonds, €288.3 billion in covered bonds, €223.7 billion in corporate bonds and €30.77 billion in asset-backed securities (as at 10 July).

Massive expansion of existing asset purchase programmes (QE)

Massive expansion of existing asset purchase programmes (QE)
* Pandemic emergency purchase programme, forecast based on purchasing volume in first four weeks; implied stepping up of purchases over the year. Sources: Bloomberg, Macrobond, Union Investment; as at 10 July 2020.

What further options would the ECB have at its disposal? It could further increase the volume or scope of its purchase programmes, for example by expanding its purchases to ‘fallen angels’ – i.e. securities that have been downgraded from investment grade to high yield. In the event of a second coronavirus wave, the banking sector would likely find itself at the centre of attention. New, potentially far-reaching containment measures would intensify the financial pressure on companies. In this scenario, insolvencies would probably increase at an extremely high rate. This, in turn, would necessitate higher allowances for losses on loans and receivables. The capitalisation of the US banking industry is comparatively solid, but credit institutions in Europe have been adversely affected by market fragmentation and years of low interest rates. The ECB has therefore prepared a series of new targeted longer-term refinancing operations (TLTROs). As part of the TLTRO in June, 742 banks from the eurozone requested a record amount of liquidity of €1.31 trillion. This source of funding at favourable rates offers banks the opportunity to make carry trades, i.e. to buy securities that generate higher yields but are subject to low capital requirements. This should ensure that the prices of government bonds from eurozone periphery countries and of corporate bonds from the eurozone also remain supported.

Consequences for eurozone periphery bonds

One risk for eurozone periphery countries is that their government bonds could be downgraded as a result of the rise in national debt. In this context, the focus is on Italy. The rating agencies are unlikely to apply greater pressure until the autumn. [WK(1] [MD(2] The expansion of the PEPP thus effectively means that the entire volume of new Italian government bonds scheduled to be issued over the rest of this year will be absorbed by the ECB. Union Investment’s experts do not believe that a high-yield rating would pose an obstacle to these purchases.

The debate about the creation of a European recovery fund is also a relevant aspect. Even though it will probably be some time before the final resolution to establish such a fund is adopted, the European Union is [WK(3] heading in the right [MD(4] direction. But Italy’s outlook also depends on how European financial aid instruments will be structured and whether spreads on Italian government bonds remain moderate. The country’s ability to service its debt hinges on how credibly it can reduce its deficit in the years ahead.

The apparent resolution of a legal sticking point recently boosted sentiment in the European bond markets. In the minutes of its meeting in June, the ECB set out the advantages and disadvantages of the PEPP. This should satisfy the requirements stipulated by the German Federal Constitutional Court regarding the legality of such bond purchases. Many market participants therefore expect that Germany’s Bundesbank will continue to participate in the ECB’s purchase Programmes.

US Federal Reserve ramps up support for businesses

The US Federal Reserve has also implemented precautionary measures in respect of a potential second wave of coronavirus. The bank has already announced plans for unlimited quantitative easing (QE) and has lowered its key interest rate to the 0.0–0.25 per cent band. In addition, fresh support measures were implemented to boost liquidity in the money market (commercial paper lending facility – CPFF; money market mutual fund liquidity facility, MMLF) and a credit facility for primary dealers (PDCF) was set up. On 29 June, the Fed launched its primary market corporate credit facility (PMCCF), which enables the bank to make direct purchases in the new issues market for corporate bonds. Bonds from investment-grade issuers and issuers who were rated as investment grade until 22 March 2020 are eligible for purchase under this scheme. This instrument will be a particularly valuable source of support in the event of a second wave of infection.

In addition, the Fed also set up a secondary market corporate credit facility (SMCCF), which initially enabled it to invest in exchange-traded bond funds, but was subsequently expanded to allow purchases of individual corporate bonds. These two facilities currently offer a potential combined volume of up to US$ 750 billion (US$ 500 billion under the PMCCF and US$ 250 billion under the SMCCF), but this volume could be topped up. Moreover, there is also a term asset-backed securities loan facility (TALF) for purchases of structured credit products based on consumer loans.

This catalogue of measures – all of which have scope for expansion, be it in volume or by including further asset classes such as equities – has significantly increased the balance sheet of the Federal Reserve. Since 2010, the Fed’s balance sheet has now grown by more than that of the ECB (see chart).

Central banks are pumping liquidity into the markets

Central banks are pumping liquidity into the markets
Source: Bloomberg; as at 10 July 2020.

The central bank also discussed the subject of yield curve control – a highly controversial topic. A move in this direction would see the US central bank follow in the footsteps of institutions such as the Bank of Japan and the Australian central bank. Yield curve control involves purchasing longer-dated (or, in the case of Australia, shorter-dated) maturities in order to prevent yields from rising too steeply and instead keeping them steady at a certain level. This approach is controversial because a pronounced flattening of the yield curve would put banks – who act as lenders and generate their income from maturity transformation – under pressure. On this basis, it is regarded as more likely that the bank will introduce the concept of ‘forward guidance’[WK(1] [MD(2] , i.e. the advance determination of a monetary policy strategy for a certain period (as practised by the ECB).

Conclusion

Against the backdrop of rising government debt levels in the wake of the coronavirus crisis and significant economic uncertainty, the central banks will need to continue to carry out proactive interventions in the market. In the event of a second wave of coronavirus in the industrialised economies, the central banks would have scope for further action to support the markets, e.g. by ramping up their asset purchase programmes. These are already providing crucial support for the government and corporate bond markets. Interest rates can be expected to remain very low for a prolonged period. This means that the challenging investment environment will persist and that carefully selected investments in risk assets (equities, corporate bonds) may be advantageous. At the same time, default risks will need to be monitored rigorously.

 

As at 2 July 2020