In response to the COVID-19 pandemic governments imposed shelter in place rules for their citizens and issued orders to close all but essential business in their country. The collective impact resulted in an unprecedented global plunge in economic activity that threatens the existence of many small and medium size businesses and a surge in joblessness in a matter of weeks as tens of millions of workers lost their job. In the U.S. more than 30 million workers have already filed for unemployment insurance and millions more are in the pipeline. In responding to this economic calamity central banks slashed interest rates at a faster pace than they did in battling the financial crisis in 2008, which is noteworthy since global policy interest rates were far lower in 2020 than in 2008.

As financial markets became dysfunctional and illiquid, central banks also injected an enormous amount of the liquidity to stabilize financial markets so the health crisis didn’t become a financial crisis. The Federal Reserve has been the most aggressive central bank, while Japan has led the way with a large dose of fiscal stimulus. The U.S. has the largest combined response when monetary and fiscal spending is combined and this chart doesn’t include the U.S.’s second Payroll Protection Program of $450 billion.

Since 2013 the Bank of Japan has left the ECB and the Fed in the rear view mirror as it has continued to buy Japanese government bonds, commercial paper, and Exchange Traded Funds (ETFs) including those owning stocks. The BOJ’s balance sheet is larger than 100% of Japan’s GDP while the ECB’s will approach 50%. If the Fed’s balance sheet reaches $10 trillion by the end of 2020 it will approach 40% of GDP. For many economists this development is a big surprise but something I expected. This is a quote from the June 2018 issue of Macro Tides and the February 2019 Macro Tides. “During the next recession, the Fed’s balance sheet could easily balloon to $10 trillion or more, as it attempts to prevent an outright deflationary debt collapse.”

The Federal Reserve began to normalize its balance sheet (think shrinking) in October 2017 through the end of August 2019. The Federal Reserve began to gradually expand its balance sheet from a low of $3.71 trillion on September 2, 2019. In the past 2 months the Federal Reserve has expanded its balance sheet from $4.17 trillion on February 17 to $6.57 trillion on April 20. To provide some prospective during the height of its third Quantitative Easing program the Fed was buying $120 billion of Treasury bonds a month. The Fed is now buying $70 billion a day!

The Federal Reserve has also made it possible for the Treasury to leverage the funds it has received from Congress by roughly 8 to 1, which is an extraordinary expansion in the Fed’s role of being the lender of last resort. This will allow the Treasury to extend more credit to small businesses through the Main Street Lending Program, Payroll Protection Program, and every other creative but necessary ‘Facility’ the Fed and Treasury Department needed to put a finger in the economic dyke.

In the November 2019 Macro Tides I discussed how vulnerable corporate debt in the U.S. would be in the next recession. “In the U.S. corporate debt as a percent of GDP is at its highest level in history at 47%, and has generated a slew of articles expressing concern since a peak in corporate debt levels has preceded each of the last three recessions in the U.S. This is a legitimate concern that will be unmasked in the next recession.” The prime vulnerability within the corporate bond market is that an inordinate amount of debt was rated BBB just one level above junk. With 3 times as much debt rated BBB (the lowest rung of investment grade corporate debt) versus BB, any economic slowdown was likely to result in a surge in downgrades that would force some pension funds to sell. I covered this risk in the July 1, 2019 Weekly Technical Review. “During the next recession, a wave of downgrades to less than investment grade could prove problematic for the corporate bond market. Many pension funds have limits on how much high yield or junk bonds they can own. A wave of downgrades could trigger a wave of liquidations that could swamp investors who own the high yield ETF (HYG) or the junk bond ETF (JNK). A close below $106.00 would indicate trouble was coming. When JNK closed below $106 in November it quickly dropped to under $98.00. In the oil price collapse in 2016, JNK plunged to under $94.00 after it closed below $106.00.”

This is exactly what occurred in February and March when an avalanche of rating agency downgrades hammered the corporate bond market and especially BBB rated corporate bonds. The amount of downgrades in March was the most since 2002, even exceeding the spike in 2009. The monthly amount of downgrades during the financial crisis persisted and only time will tell if the total amount of downgrades during this crisis eventually exceeds the financial crisis. As the chart (below) shows the Junk bond ETF (JNK) plunged after it closed at $105.64 and below $106.00 on March 6.