“Today’s liquidity conditions are like the waters receding before a giant wave”, Zoltan Pozsar begins, kicking off #27 in his “global money notes” series for Credit Suisse.
Pozsar – whose name is almost synonymous with short-term funding markets – famously warned that the September repo squeeze presaged a more dramatic seizure over the year-end turn if proper precautions weren’t taken by the Fed.
Thankfully, his worst-case scenario – where the “world stops spinning” – didn’t play out. He subsequently suggested that his note may have helped prevent that outcome.
On Tuesday, following the first “emergency” (i.e., inter-meeting) Fed cut since the crisis, Pozsar is out with a series of recommendations for the central bank at a time when a deadly virus threatens to bring economic life to a standstill from New York to London to Beijing.
He begins by noting that the disruptions caused by the various containment measures put in place across economies “will lead to missed payments globally [and] missed payments will force more and more firms to become deficit agents”.
That, he warns, will “cascade” making regional banking systems themselves deficit agents.
Of course, it’s not local currency payments he’s concerned about, but rather dollar funding. Here’s the setup:
FX reserves are plentiful, global banks have liquidity buffers and the standing FX swap lines are there to add liquidity. But FX reserves need to be monetized, the outbreak may reveal some design problems of Basel III, and FX swap lines are not for everyone. A lot can go wrong with the system’s immune system.
First of all, Pozsar says that if the Fed continues to cut rates but doesn’t commit to open-ended liquidity support (via the balance sheet), billions of inflows into money funds (which ended up funding Treasury holdings for dealers and hedge funds) could find their way back into the bond market “just when the funds are needed in the money market”.
Importantly, James Sweeney is also listed as an author on the note, which, if you’re familiar with Credit Suisse’s research, suggests Pozsar intends to bring in some of Sweeney’s work on the cycle. Indeed, that’s how he sets it up. To wit:
Normally, the global IP cycle and funding spreads dance to different tunes and their impacts on asset prices can offset or amplify each other. The coronavirus outbreak and the shock that preventative measures introduced to the global IP cycle and services activity mark a rare occasion when our two publications meet.
Pozsar and Sweeney characterize the supply chain as simply a “reverse” payment chain. When supply chains face a massive disruption (i.e., production shuts down), it presages missed payments by someone, somewhere and then, a bunch of someones, in myriad locales.
One thing that makes this situation unique is that due to the biological nature of the shock, the services sector is imperiled too.
“A sharp shock to Chinese manufacturing will have a disproportionate impact on payments in the global goods sector, so a sharp IP shock is therefore a potential risk for widespread financial distress and missed payments globally”, Pozsar and Sweeney write, before noting that “the current IP shock coincides with a shock in services – a sector which is seldom volatile or cyclical”.
“Missed payments in manufacturing are one thing [but] missed payments in manufacturing and services at the same time are another”, the two go on to say, adopting an ominous tone.
Obviously, local central banks can cope with funding pressures that relate to debts denominated in their home currency. The issue, as ever, is dollar funding. And whether the Fed responds in a timely way with the right tools and facilities.
“Dollar funding is always the orphaned child of crises as the regions where the pressures flare up have no control over it, and the Fed, uncomfortable with the reality of it being the de facto central bank of the world, always takes its time to step in to ease the pressures until it’s absolutely necessary”, Pozsar writes.
As he launches into a dissection of COVID-19’s funding market effects, he helpfully describes the situation as a “tilted J-curve”, where the initial demand destruction creates a positive funding effect. To wit, from the note:
The initial positive funding impact comes from three sources: (1) Less demand for commodity finance, as commodities are not in demand and don’t need to be mined and moved around (less demand for oil, coal and copper). (2) Less demand for trade finance as factories remain shut across China and there is no demand for intermediate goods. (3) Less demand for shipping finance as new commodities and intermediate goods are not being sourced and because final goods are not being shipped.
Of course, in those circumstances, demand for bank funding falls (trade grinds to halt and economic activity doesn’t need to be financed), and because banks have likely pre-funded expected customer needs, the liquidity impact for banks is actually a temporary boost.
The key word there is “temporary”. After what Pozsar calls a “grace period”, the missed payments start to pile up, and remember, fixed costs don’t simply disappear because there’s a virus going around. This is the path to becoming a “deficit agent”.
At the beginning of the next section, Pozsar delivers the stone-cold reality of the situation some firms are likely to find themselves in. “Debt is agnostic to your circumstances – it must be serviced, otherwise you are bankrupt”, he writes.
Intuitively, the situation gets exponentially worse as it ripples back up the supply chain, because all along the way, each firm has its own fixed costs and debt to service. When, for example, “the assembler/seller of final goods in China does not have inflows to pay the suppliers of intermediate goods… in Japan, Korea and Taiwan”, those firms’ inflows dry up too, and before long, everyone is a deficit agent.
When you throw in the fact that, according to the BIS, corporate borrowers globally are weighed down by growing piles of dollar-denominated debt, you can start to see where the problem comes in.
Servicing that debt by definition runs down USD balances. Even if maturity profiles have been extended well into the future, interest payments must be made. And how, do you imagine, most firms fund their debt servicing costs? Hint: It’s from operating income. It’s hard to generate operating income when you aren’t operating.
This suggests that firms will have to tap banks for dollar funding to service their debt.
This translates very easily into the services sector. Here’s a straightforward hypothetical (or not) from Pozsar and Sweeney:
Consider, for example, an Asian airline that stops having inflows due to reduced demand to fly to, from and across Asia. The initial positive impact on funding comes from the reduced demand for jet fuel – which is also mirrored in the reduced funding needs of commodity houses that would fund the sourcing and shipment of jet fuel for airlines – but the deficits accumulate over time from keeping pilots and cabin crews on payroll, paying the rent on parking spots and gates at hundreds of airports the world over, and servicing the debt that finances the fleet of aircrafts. The longer passengers don’t fly, the longer the planes are grounded, and the more the airline’s dollar deposits are depleted: the airline gradually becomes a deficit agent, like chipmakers above. Hotels are next…
That’s when it gets really dicey. Because at that point, as firms run down their dollar balances and look to borrow dollar funding, the banks themselves come under strain. Then, the pressure starts to build in the interbank market.
This won’t happen immediately. That is, the transformation of struggling manufacturers and service firms to deficit agents won’t translate to interbank stress overnight. There are a variety of liquidity buffers which Pozsar spends two entire pages detailing. Ultimately, though, he renders this judgement:
A flood of corporate drawdowns could force the entire banking system into becoming a deficit agent – the extreme example of the outbreak infecting the top of the hierarchy: from firms to individual banks, to country level banking systems, to financial centers and, as contagion spreads and turns the global banking system into a deficit system, to the Fed – the only entity that can serve as a surplus agent to match the needs of a deficit system. No, that’s not an overstatement. We saw something similar in September!
But unlike what happened in September, this situation is difficult to forecast, game out and plan for. After all, we knew the corporate tax payments and Treasury settlements were coming. What about missed payments due to the type of global disruptions described above?
Pozsar says it’s “not unrealistic” that missed payments could reach $200 to $300 billion, an amount he says could “easily” swamp funding markets in New York.
“If reserves were insufficient to deal with routine tax payments and Treasury settlement in September, and if the Fed only added just over $150 billion of excess reserves since then, a mass drawdown of corporate credit lines due to missed payments could push the US banking system back into deficit in short order”, Pozsar warns, before making another crucial point. Read on.
What’s “comfortable” for banks in terms of reserves obviously depends heavily on what we’re talking about in terms of adverse circumstances. The virus could get worse, and if it does, all of the dynamics outlined above will be amplified. In that scenario, banks will naturally be inclined not just to set the “floor” higher (if you will), but also to hoard the reserves they do have in order to inoculate themselves.
He then lists a trio of dynamics which he says may begin to manifest in repo and FX swap markets. Here are those three dynamics, from the note:
(1) U.S. banks gradually starting to pull back from lending in the repo market and starting to monetize Treasuries to fund the drawdown of corporate credit lines. (2) Tech companies starting to monetize their bond portfolios to roll the lifeline they extended to their strategic suppliers in various corners of Southeast Asia. (3) Foreign central banks starting to tap into their FX reserves to help local banks, and the pressures these flows might cause to repo and FX swap markets.
Clearly, this suggests the Fed won’t be able to step back from its liquidity provision role after tax season.
Pozsar then launches into a series of highly illuminating examples that drive the point home in characteristically trenchant fashion. Here’s one passage on tech firms, for example:
Second, tech companies repoing their bonds to fund their suppliers are a similar story, but unlike banks, their port of call won’t be the discount window, but the repo market. Now, if the Fed is the marginal lender in the repo market now to the tune of $150 billion, a new marginal supplier of collateral will give the Fed no choice but to upsize its repo ops.
Now think about what happens when deficit firms in hard-hit areas of the world beget deficit banks which in turn plead with their national central banks for help. Here’s the China example, from Pozsar (and I’d paraphrase this but, honestly, there are times when it’s simply not possible to paraphrase Zoltan):
In the case that banks in China are overwhelmed with a drawdown of dollar deposits, their natural port of call will be the PBoC for dollar liquidity. In turn, the PBoC’s port of call will be dealers first in Hong Kong and London and then the primary dealers in New York. The PBoC – like all major central banks – keeps a portion of the liquidity tranche of its FX reserves in FX swaps, where they lend U.S. dollars in exchange for euros and yen. But if they need to start lending dollars to local banks through bilateral arrangements, China effectively flip-flops from being a lender of dollars to being a borrower of dollars in the FX swap market, and dealers in Hong Kong and London now have to find the missing link to their previously matched $/¥ and €/$ FX swap books. As the PBoC goes from funding carry traders in the FX swap market to helping local banks bridge dollar deficits, it naturally transmits local imbalances globally and carry traders end up holding the bag… …the Fed’s dollar swap lines could be called by FX swap dealers in London. Once the PBoC exhausts its dollar liquidity in cash markets like the FX swap market, it will next tap its Treasury portfolio and will either repo or sell those Treasuries through dealers in New York to raise more dollars to lend to local banks. The one place the PBoC won’t go to raise dollars is the Fed’s dollar swap lines – because it has no line to the Fed! China’s dollar needs will therefore stress private balance sheets in London and New York, not public balance sheets, unless a swap line between the PBoC and the Fed is created.
And believe me when I say that he goes on. The full note is 17 pages and it is every bit as in-depth as you’d expect from Pozsar who has a reputation for rigor that’s pretty much unsurpassed as far as “mere” analyst notes go.
What, you might be asking yourself, does he actually recommend the Fed do to counteract all of this? Well, first, he enumerates four points of stress that he sees “striking first” – and he emphasizes that these will come “in this specific order” (which in this case means moving inward from the periphery to the core). To wit:
(1) peripheral cross-currency bases (e.g., KRW/USD) as missed payments grow; (2) €/S and $/¥ bases as reserve managers stop lending in the FX swap market, to help banks and banking systems deal with dollar outflows in their jurisdictions; (3) U.S. dollar Libor-OIS spreads as banks start fixing their LCRs that are being damaged by outflows of operating deposits and corporate credit lines; and lastly, (4) o/n GC repo markets as FX reserve managers and large banks are scrambling to turn collateral into cash to fund banks’ and corporate customers’ liquidity needs.
In the final analysis, Pozsar warns that while rate cuts like we got on Tuesday can help, they may also make things worse if they re-steepen the curve too dramatically. Instead, he recommends the Fed do this:
Combine rate cuts with open liquidity lines that include a pledge to use the swap lines, an uncapped repo facility and QE if necessary.
While it’s impossible to say, with any degree of certainty or specificity, how markets would have reacted on Tuesday if, during the press conference, Jerome Powell had launched into an analysis akin to Zoltan’s, on the way to announcing a plan that resembles what Pozsar captures in that final excerpted passage, it’s probably safe to assume that many market participants would have come away highly impressed and feeling a lot better about things.
More simply: If the Fed adopts something similar to Pozsar’s plan, then at least if we all perish from a deadly respiratory disease, we’ll die knowing that had we lived, liquidity lines would have been available and dollar funding assured.