Even the Federal Reserve can’t push on a string.
It’s probably not a coincidence that a day after Donald Trump threatened (for the umpteenth time) to demote Jerome Powell, the chairman of the Federal Reserve Board pulled out one of the last arrows in his quiver—and then watched it fall to the ground. Late Sunday, Powell announced that he would cut short-term interest rates another 50 basis points, to zero, and—this is the important part—said the Fed would spend $700 billion buying all sorts of different debt securities and keep them on the Fed’s balance sheet. This little maneuver in Fed-speak is known as quantitative easing.
You may remember our old friend quantitative easing? That’s the program the Fed instituted after the onset of the 2008 financial crisis in order to push up the price of long-term debt securities, driving down their yield, or the effective rate of interest the debt pays. The idea was to drive down the cost of borrowing for all sorts of companies and corporations. It worked spectacularly well, for a while, but then probably went on for too long. Between September 2008 and February 2017, the Fed’s balance sheet ballooned to $4.5 trillion, from around $900 billion. Under Powell, a slow unwind of the QE program (versions one, two, and three) began, reducing the Fed’s balance sheet to around $3.8 billion. Then, about a year ago (possibly under pressure from Trump, though who knows), the Fed started buying long-term debt securities again—this became known on Wall Street as sort of a stealthy QE4, and its balance sheet returned to nearly $4.3 trillion.
Now, in one fell swoop, there is no more charade. QE5 is here with a vengeance as is a return to what became known in the last decade as ZIRP, or zero-interest-rate policy. But what had, in years past, instilled confidence in investors—lots of capital available at cheap rates—has backfired now. Investors are utterly unimpressed, largely for at least three reasons: one, the coronavirus doesn’t care about interest rates; two, interest rates have been so low for so long anyway, those companies that remain creditworthy (a big caveat) have long been able to get all the capital they need and those that are no longer creditworthy, or that are perceived to be uncreditworthy won’t be able to get access to capital regardless of how low both short-term and long-term interest rates are. This is known on Wall Street as “a flight to quality”; and, three, if the Federal Reserve, with the best information around, is taking such drastic measures on a Sunday afternoon, then, well, things are probably even worse than we already suspect them to be. And so instead of boosting investor confidence, the Fed has strafed it. No surprise, the Dow Jones Industrial Average gave up on Monday most of the gains it clawed back on Friday. Welcome to the new normal.
This matter of the markets deciding who is creditworthy and who is not is a vital one, and it’s happening faster than you can imagine, especially since most people are, rightly, focused on their health. As is often the case, recent trading in the high-yield market is a dramatic window into what’s going on. Think about the Sorting Hat doing its thing in Harry Potter. That’s what the high-yield market is doing now. It’s deciding which companies will live and which companies will, metaphorically (or actually), die. Back on February 20—when it looked like trees could grow to the sky and markets were still exuberant—the average yield on a high-yield bond was the absurdly low 5%. That means investors weren’t getting paid for the risk they were taking in owning high-yield debt, and seemed to be just fine with that.