The last few months have seen what dystopian movies have depicted many times before, a virus that has spread to almost every single country of the world. Thankfully though, there are no aliens or apocalyptic war scenes to be witnessed in our version. What we are witnessing, however, is an economic shock to the system unlike any before.
The response from most Central Banks across the world has been to unleash unprecedented stimulus into the financial system: interest rates were cut, loans and asset purchase programs extended or enlarged and regulation became more accommodative. Importantly, the stimulus injected is indeed unprecedented: the Fed, for example, had never moved interest rates in increments greater than 0.25% since the Great Recession yet it lowered the federal funds rate twice during March, once by 0.50% and a second time by 1.00%.
But how, then, has this affected financial markets?
By looking at risk assets as main components of markets, the impact witnessed points towards a profound distortion in the market whose impact may put Central Bank stimulus increasingly into question.
Risk assets and the portfolio rebalancing effect
Risk assets can be defined as those whose return is not guaranteed and thus carry a risk premium. They generally refer to assets that have a significant degree of price volatility, such as equities, commodities, high-yield bonds, real estate, and currencies.
The main channel through which risk assets are affected by Central Bank stimulus is what is coined the portfolio rebalancing effect. The vast asset purchase programs run by say the ECB and the Fed increase the demand for assets that are relatively safe (since such Central Banks enter the market activity as buyers) and they thus reduce the yields on such assets. This in turn induces investors to shift their investments towards assets with higher expected returns which naturally are those that are associated with more risk. The result is a portfolio rebalancing from ‘safe’ assets (often longer-term securities such as government bonds) to those deemed more risky (e.g., corporate bonds and equities).
The aforementioned phenomenon is especially important for traditionally more risk-averse investors such as pension and insurance funds since with interest rates close to 0% or less, government bonds no longer provide them with the returns needed to pay their pension and insurance claims. Indeed, a recent survey by State Street found 33% of insurers in the US planned to expand private credit investment in the short term, which is exactly the move anticipated by the portfolio rebalancing effect.
Other figures related to corporate debt shows the existence of a portfolio rebalancing effect clearly:
High-grade yields averaged just 1.83% in the first week of August (Bloomberg 2020) which shows that investors are willing to hold such risky debt for a very low return
Junk-bond volumes for 2020 are up approximately 36% YoY (Barclays, 2020)
The volume of corporate euro investment-grade bonds with a negative yield on the Tradeweb system rose to 1.4tn euros on July 31st, equating to 42% of the market
A year earlier that number was <0.5tn euros or 17.9% of the overall market
This last bullet point especially points towards a profound change in the market contrary to what fundamentals would predict. Indeed, the fact that government bonds in Europe are trading at similar yields to corporate bonds, implies that the whole mechanism behind the concept of risk premium has been distorted: lending money to corporates, because of a real risk of their default, should theoretically never yield negative rates. How is this possible then? There are two main phenomena at play. First is the ECB, which through its asset purchasing programs has contributed to demand to such an extent that the resulting high prices represent a very low yield. Company credit instruments, for example, account for about 20 percent of the European Central Bank’s Pandemic Emergency Purchase Programme. The Federal Reserve went a step further by including “fallen angels” into its program — companies that fell into junk bond status as a result of the Covid-19 crisis. Second is the more aggressive market players, such as hedge funds and certain asset managers, who have been taking advantage of Central Bank stimulus by buying bonds - even at negative rates – and betting that the ECB will buy them later at a higher price, thereby contributing to further lower yields.
There are a few important implications of this dislocation between what traditional economic theory would predict and what is witnessed in the market. Firstly, the distortions created by Central Bank stimulus has resulted in risks being priced out of the market. The asset purchasing programs run by the say the Fed or the ECB have effectively introduced a cushion of security where they have placed themselves as buyers of last resort. This has induced a move towards more risky assets and comes as the pandemic leaves companies vulnerable to credit rating downgrades and greater insolvency risk. S&P Global, for example, predicts that the rates of $640 billion of European and U.S. bonds will fall into junk status by the end of this year. Secondly, although it can be argued that this move has already been played out, there are still signs that the continuous and unfaltering support communicated by the Fed and ECB have instilled certain confidence in investors that their ‘buyer of last resort’ status is likely to remain in the foreseeable future. The recent rally in Bitcoin, for example, is just one of many signs that suggest the move has not entirely been played out. On top of a blatant disconnect between how the stock market is doing and how the economy is doing, the distortions noted above may put the impact and substance of central bank stimulus increasingly into question.