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Is a promise enough?

  • Financial Analyst
  • Blog post submitted on 29th May 2020

The adage “actions speak loader than words” may hold true for most things in life, however it doesn’t seem to hold true for central banks. Following the announcement of unprecedented measures by the Federal Reserve, only a fraction of the multitrillion dollar emergency lending facilities has been deployed, more than two months after the US central bank’s promises of action helped stoke a powerful rebound in financial markets.

One of the more outlandish measures taken was the creation of facilities to buy risky assets ranging from junk bonds to local government debt, which has proven to be a key cog of the Fed’s effort to stabilise markets and boost the US economy, alongside an unprecedented expansion of its balance sheet through the purchase of trillions of dollars of Treasury bonds.

Despite announcing an array of 11 emergency facilities in March and April, which promised to make more than $2.6tn available, only five are fully or partially operational and usage reportedly stands at just $95bn, which equates to less than 4 per cent of the funds available.

The limited uptake of some programmes and gradual rollout of others underlines how the US central bank has been able to calm investors just by promising future action, but also raises questions about the sustainability of the recent rallies in debt and equity markets.

The US stock markets have rebounded to within a few percentage points of their all-time highs, and American companies have been able to issue record amounts of debt, even though large parts of the global economy remain closed. In large measure that is because investors have credited the central bank with eliminating the threat of a financial crisis, putting a floor under asset prices and working to stimulate the US economy as it reopens.

Markets have also been quick to brush off the increased tensions in US-China relations, with an increasingly risk-on mode ignoring the potential headwinds, settling back into the safety and comfort of central bank support.

Indeed the Fed’s balance sheet has smashed its previous record, with consensus forecasts estimating it to surpass 45 per cent of GDP by year-end compared to global financial crisis of 26 per cent should the full extent of the measures be implemented.

The fact that usage of facilities so far has been low is considered to be the ultimate win-win situation for the Fed, with the promise appearing to be enough to comfort investors and return confidence to markets. Indeed Thursday marked a potential turning point for unemployment figures in the US, as they dropped for the first time since the crisis began.

Despite the market indices rallies, the distribution of the turmoil is not as universal as may seem, with small and medium-sized businesses (SMEs) still in the thick of the (post) lockdown, and with aggregate demand expected to take beyond 2021 to recover to 2019 levels, the risk of default and damaging pain for the larger segment of the economy remains looming in the background.

One thing that the Fed and other central banks definitely got right this time round compared with the Global Financial crisis of 2008, was the swiftness with which they provided liquidity facilities to those in need, avoiding large bankruptcies and subsequent contagion effects. In addition, the actions taken by the Fed were also crucial to increase market liquidity and corporate liquidity. The latter being a crucial element for companies to raise capital following practically a non-existent primary market for an entire month.

Continued support to SMEs remains vital in the eventual recovery to our previous norm, and should the ability of the world’s economy to fully re-open come sooner than anticipated, via vaccine or otherwise, the central banks will definitely be touted as having played an integral role in the smoothening of this grave human and economic crisis at little cost to the taxpayer.

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