The Fed’s actions in March revolved around how important a working credit market is to the economy… let’s see if it’s still functioning well
In the midst of the market meltdown in March, thanks to the Fed’s SWAT team, keeping credit markets safe was prioritized.
The Fed understood that credit markets are of the utmost importance. They have the ability to affect the broad economy and equity markets.
One important indicator of the health of credit markets is signalling continued easing of credit, reducing the risk that any sell-off that could occur in the near-term turns into a market collapse.
Today, with the help of Uniform Accounting, we will look at how easy it currently is for companies to obtain credit.
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The Fed realized the need for a finance SWAT team as the agency reassessed its role in the economy following the 2008-2009 financial crisis. To get ahead of future possible events, the Fed created the Division of Financial Stability, colloquially known as FS.
The FS team is tasked with identifying all the ways the economy could melt down, with a focus on the most fragile parts of the broader economy. The 50 economists working for the FS need to be creative when thinking of possible scenarios so the Fed is able to respond to any crisis. The FS team also needs to think of how the Fed should respond to each crisis.
Everyone brainstorming hopes 99% of the scenarios will never play out. However, the plan for a pandemic was in the list of developed plans.
Due to the FS team’s forward thinking, the Fed was able to spend more time responding to the crisis and less time fighting over which course of action to take.
The Fed used the playbook drafted by the FS team to stabilize the economy. The Federal Open Markets Committee (FOMC), the Fed’s monetary policymaking body, quickly lowered interest rates to 0%. This action encouraged households and businesses to continue borrowing money and kept money flowing throughout the economy.
The Fed also helped stabilize financial markets through buying government debt securities. Another step the Fed took was to support the flow of credit in the economy. The Fed created many temporary facilities to support credit markets and businesses of all sizes, allowing many to survive through stay-at-home orders.
Overall, the Fed took nine different programs from the FS team. Without a prewritten plan, the Fed would not have been able to react as quickly to the crisis, letting it get worse. However, the Fed was able to prevent a total seizure of credit markets and so far, has not allowed the pandemic to balloon into a credit crisis.
The Fed took such aggressive actions in March because it understood the importance of credit cycles.
We have talked about the importance of credit cycles before and we focus on it as a heart of our macro analysis, our Market Phase Cycle report. This is because credit cycles drive economic and equity market cycles.
Without access to credit, liquidity begins to dry up and can bring the economy to a halt. Short-term downturns can become catastrophic to companies if they cannot borrow money to cover fixed costs. The pandemic created one of the sharpest short-term economic downturns in history, with real gross domestic product (GDP) falling almost 35% in the second quarter.
The only way for companies to survive a drought in demand was through the use of credit.
Now that we are more than six months removed from the trough in the stock market, it is important to take a look at credit market signals, to make sure none are rolling back over to concerning levels.
One way we can measure the health of the credit market is by looking at the corporate cost to borrow. This way we can see if corporate credit is frozen or free flowing.
To do this, we can look at credit default swap (CDS) levels and the risk-free rate. A CDS is an agreement in which the seller of the CDS compensates the buyer in the event of a default.
The current CDS levels tell us corporations have easy access to credit, and low costs to borrow, which incentivizes them to not hold back on borrowing if they need it.
This means low risk of corporate defaults. With CDS rates low, companies are aided through easy access to refinancings and low debt servicing costs. This is because bonds themselves pay a lower interest rate, which means less payment to investors and more money saved for companies.
Cost for corporates to borrow has of course also fallen since the spike in late March. This has taken place across both risky (high yield) and safe (investment grade) bonds.
Even more telling for investors, our Intrinsic CDS (iCDS) shows this drop is backed by economic reality.
Our iCDS calculation is able to show the fair value of credit, and quantifies what investors should be paying to have their risk covered. As the graph below shows, iCDS levels are even lower than CDS levels, justifying the level they currently float at.
The above graphs should give investors confidence in the current state of credit markets. With debt so inexpensive, the risk of mass default from companies dragging down the economy is negligible, and therefore the risk of the market dropping significantly is minimal too.
Companies have few barriers to entering the credit markets, implying they can access the liquidity they need. Clearly, the FS team’s task of preparing for any potential challenge has worked.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research