The Monetary Policy Response to Coronavirus (w/ Nouriel Roubini)
ASH BENNINGTON: I think most people think of you in your background in acting in the academic world, but you've also spent a long time in government and in supranational organizations. I think I can get these right, you're at the IMF, the World Bank, the Fed, Bank of Israel, at the White House, the Council of Economic Advisers during the Clinton administration, at Treasury is a senior advisor Tim Geithner, help us understand, especially on the monetary policy side, I think that a lot of people have been going up to the, for example, the Fed website, they see this alphabet soup of liquidity facilities, in addition to the low interest rate policy that we're at, the reserve policy. Help us understand how some of these liquidity facilities actually function and how they transmit into the real economy some of that liquidity. NOURIEL ROUBINI: Well, these liquidity facilities have the falling feature, there are many parts of the financial system that are stressed, that suddenly everybody wants cash, even government bonds and let alone things like corporate bonds or equities becomes too risky. When there is this scramble and everybody's going from equity to government bonds, and from government bonds into cash, then there is a demand for liquidity. If you don't find that liquidity of this crisis in what's called funding market with very exotic markers like repo having interest rates not close to zero, but close to 5%, 10% like it happened even last year. Some of it is highly technical, but essentially, think of it this way to think of how the market got distress in March. Usually, when there is risk off, stock market goes down, but then bond yields go lower because people move money from equity into safe US Treasuries, so bond yields go lower. While you're losing money in your equity portfolio, you make money in your bond portfolio. Suppose you're a typical investor that they recommend you 60/40. 60 equity and 40 bonds. Whenever there is a negative shock, you lose money on equity, and you make money in your bonds because the yield goes down, the price goes up, and that's a mark to market game. That's the way you are insuring yourself. Most of modern portfolio theory, most of institutional investors, even the hedge funds, what is the risk parity that Ray Dalio and Bridgewater was doing is a variant of 60//40. Instead of being 60/40, you're enhancing your bond side of the portfolio by leveraging it because you know that when there is a shock to equity, you want to be even more than 40 into bonds. Between this year, between March 9 th, and March 21st, for almost two, three weeks, something crazy occurred, and the crazy thing occurred was the stock market was in freefall going down 10%, 20% and then 30%, and bond yields that initially went down because initially, in February, they went from about 1%, down to 0.3. Initially, the market reaction was the normal one. Stock market's down, bond yields are down, you lose money on the equities, you make money on bonds, but after March 9 th , and until March 23rd , something crazy happens. The crazy thing that happened was that bond yields in the Treasury market, instead of going lower towards zero, they went from 30 basis points in a matter of two weeks to 125. You had an increase of almost 100 basis points in bond yields that made you made losses of 10% on your own bigger bonds. On this portfolio, 60/40, even Ray Dalio's risk parity, why did they lost so much money in March? Because they were losing money on equities. They were losing money on bonds. This was not supposed to happen, because the risky asset go down in price, but safe asset goes up in price. During that three-week period, government bonds were going down in price, not just credit, government bonds, safe, treasuries were going down in price, gold was going down in price, the Swiss franc was losing, the yen, so every risky asset, whether it was treasury bonds, or bunds or JGBs or Swiss franc, or yen or gold was going down in price so there was nowhere to hide. The only place where you could hide was literally cash, was the only thing that gives you zero return but doesn't fall in price. We have not seen this thing ever before. There were periods of stress during the Global Financial Crisis where we have three weeks in which every asset, risky asset then safe assets were collapsing in price so you're losing money. That's why the genius of Ray Dalio lost a fortune on his risk parity portfolio. It was supposed to be the portfolio does well in good times or bad times. Even the smartest people in the world lost money. All the quant funds lost money. Why? Because the normal correlation between equities and bonds broke down. Instead of one going up and the other going down, both of them were going down and you were losing money. That was the liquidity shock. What happened was that when the Fed decided then unlimited QE, support money market, support commercial paper, support high grade, support that give liquidity to the banks, to non-banks, primary dealers, everybody in the financial system. The investment banks did not have access to the liquidity of the Fed, that's why they were leveraged to sell everything. As they were selling everything, even Treasury were collapsing. Once the Fed realized we have a problem of liquidity and we need to provide liquidity and they did everything, then things normalized. Stock prices were going down still after March 19th, they were going down at least for another week, but bond yields that went to 125 went back to 75 basis points. The normal correlation became normal because the shock to the market was one of illiquidity. Once you've got the market liquidity, at least you had safety. You had safety in gold, you're safe in Treasury and you are safe in other things. There was a massive liquidity shock that was destroying every historical correlation. There was no to hide, but cash and there was not enough, of course, cash out there until the Fed started to print. They printed stuff of the order of 70 billion every day. Think about the printing machine, everyday buying 70 billion of treasuries. Within a matter of 10 days, you have almost a trillion dollar. That's what the Fed did, they became a huge, the biggest printing machine in the world. There was a liquidity problem over a lack of dollar, not only in US, but also in the rest of the world, in Asia, in Europe. What did they do? They restarted the swap lines, that means that if you are the ECB or Bank of Japan, you can borrow dollars from the Fed, hundreds of billions, lend it to your banks, and your bank can lend it to your corporates. That's why the dollar was skyrocketing in that period, there was a scramble for liquidity. There was a dollar illiquidity and the dollar was going through the roof. You get this weird phenomenon of dollar in spite of the Fed easing money going up rather down in value. It was again the same illiquidity, the shortage of dollar liquidity was becoming lost. This was just something we've never seen before. ASH BENNINGTON: Do you think there's still systemic risk there? There was a lot of worry initially about the breakdown of those correlations, about the unwind of the risk parity trade, has that trillion dollars in liquidity backstopped it sufficiently or is there still potential systemic risk in the future if that correlation breaks down again? NOURIEL ROUBINI: Well, the systemic risk doesn't come only from that correlation breaking down and what the Fed right now has done for the time being stabilizing that correlation. The systemic risk comes from the amount of debt and leverage in the system. It's not just that debt and leverage that finance stock market position, most importantly, the structure around of debt markets. We have essentially, corporate debt within CLO, leveraged loans, high yield and high grade that is at historic highs, and the debt crisis was going to happen regardless of. In the household sector, is that who's going to pay your student loans, your auto loans, your mortgages, your credit cards if this is going to become a great depression? Currently, the bank look like safe. Why? I like the non-banks and the shadow banks, they have liquidity and they have capital, but that capital buffer is for a regular recession. It's not the capital buffer for a greater recession or for a greater depression. People say shadow banks that financed the corporate sector are going to go bust, but many of these shadow banks by the way, PE firms and capital markets and prime brokers and insurance, where do they find themselves? They find themselves from banks. At the end of the day, the money comes from the banks. If they go bust eventually, banks are going to lose money. You have the massive exposure of the banking system to both commercial and residential real estate and to consumer credit, and also to small businesses. The current guarantee says that you do a credit alone guaranteed by the SBA, you're going to be essentially guaranteed 100% up to 10 million for each one of these loans for a maximum of about 350 billion. Now, 350 billion is spare change. If many small business are going to go bust and we're speaking about trillions of dollars of bank loans, then those MPS are going to sharply rise if you have a greater depression and the banks could be in trouble. The systemic risks come from the credit markets, and the debt funds and the credit funds, they can go bust and cause that fire sales, it can go through a seizure, and then the default and the crises in the corporate debt market and only the high grade is being backstopped by the Fed, and it could then spread into the banking system. That's a fundamental source of that systemic risk. It's not just risk parity, risk parity investors in Ray Dalio's fund can lose money. That's not the key thing. There are bigger things happening.