The Fed is going to expand its market interventions to prevent another stock market crash. But should the Fed really jump in every time markets make a move? And what economic perversions will this form of monetary socialism eventually trigger?
The U.S. Federal Reserve announced it’s going to start buying individual corporate bonds worth up to $750 billion on secondary markets. That’s a first-ever, although the Fed has also been buying bond ETFs over recent weeks.
With the new stimulus package, the Fed will essentially buy a portfolio of corporate bonds. Issuers must have at least a BBB- rating, which is the lowest level of investment-grade, meaning those are companies with average creditworthiness whose ability to service debt can quickly collapse in case of an economic slowdown.
Why is the Fed intervening in the markets now?
The Fed attempts to stabilize stock markets. The additional demand for bonds will continue to push bond prices and tighten spreads, thus sending liquidity into equity markets.
This may be the Fed’s reaction to the retreat of the S&P 500 last Thursday when fears of a second wave of COVID led to panic selling. After the liquidity crisis in early March, the Fed probably didn’t want to take any risks.
The question is if central banks should really step in every time the market shows signs of a downturn? Let’s not forget that these market interventions have their side effects.
The ugly side of monetary socialism
The U.S. bond market is already dysfunctional today. In a classic liquidity crisis, market participants no longer lend each other money, resulting in a credit crunch. This is exactly what happened in March, until the Fed stepped in – rightly so, because during a credit crunch, even companies with good credit ratings no longer receive money and may have to file for bankruptcy.
Today, however, the opposite is the case. Although we are in a recession, investors are providing money to companies with high levels of debt and low credit ratings. According to UBS, this activity is so stark that it has pushed down the expected default rate on loans to these companies to 4% over the next 12 months in the U.S., compared to the 6% average.
The Fed’s market interventions are thus leading to a perversion of bond markets, because companies that are supposed to have a higher default risk during the recession can now refinance at even lower rates.
The good news of all of that is that COVID will probably not cause mass bankruptcies. The bad news is that the bubbles will grow, and the zombification of the economy will continue. COVID probably won’t be the crisis that’s going to flush out whatever excesses have been building up in the credit market.
What does that mean for the future? Well, either the next stock market crash will be even more massive, or the continuing loss of productivity will lead to declining economic growth, and the Fed will eventually own the US-debt capital market.
How long can this form of monetary socialism continue?