Yellen: Expect deep scars from this crisis

Hamish Douglass, Chairman and Chief Investment Officer, spoke with Janet Yellen, the most recent former chair of the Federal Reserve, and an adviser to Magellan, about the covid-19 health and economic crisis. The pair discuss the response of the Federal Reserve and how the crisis of 2008-09 has given guidance to the response. They talk about the economic impact and Janet explains why a Nike swoosh-like recovery is more likely than a V-shaped bounce back. They discuss the struggles of emerging markets, the risk of inflation and end on what they find to be optimistic about.

The Fed Response

Hamish

This probably has to be one of the most extraordinary periods in history. The uncertainty of what’s going on and what lies ahead makes it difficult to know what to do. Janet, it would be good to get your view of what’s happening with the Federal Reserve. The central bank is being aggressive as it was in response to the global financial crisis. What is similar about this crisis to 2008-09? And what is different about this crisis?

Janet

What’s different about this crisis is that this downturn was induced by a non-economic shock, the pandemic. And that’s different from 2008-09 or any other downturn that I can remember. The 2008-09 global financial crisis was induced by deep-seated problems in the economy and the financial sector; namely, incredible leverage in the banking system, a house-price bubble, rapid credit growth, weak underwriting standards and overindebted households. And that was a set of balance sheet problems that had to be worked off before the economy could recover. And that was a time-consuming process.

Now, if tomorrow a vaccine were invented, we all had it and the health risks were to end, the economy could largely go back to normal and the pre-pandemic situation when, even allowing for some challenges, the US economy was in good shape in a macroeconomic sense. But the health risks are unlikely to end quickly. And if they last a long time, as I expect, there’s going to be a lot of scarring. Companies in the US started this crisis with a lot of debt and they’re being forced to take on more. So it’s going to be necessary for them to repair their balance sheets. 

There are likely to be significant corporate failures and that points to weak investment and employment heading into the recovery. 

Household finances are likely to suffer damage. They are going to need to restore financial buffers. The government has been doing a lot to support the economy. I hope some of that will continue. But the government too will end with a lot more debt and that will likely diminish future fiscal flexibility.

Hamish

Janet, would you maybe explain in simple terms what the Fed has done in this crisis? What tools has it used?

Janet

The Fed has acted quickly and forcefully and these steps fall into two categories, monetary policy and emergency lending. With monetary policy, the Fed quickly lowered the overnight short-term interest rate target, the Fed funds rate, effectively to zero and it essentially promised that the rate would stay there for a long time. That’s helped to bring down longer-term rates. The Fed also began unlimited asset purchases. At first, these were oriented towards market functioning, which was highly impaired. But in about two weeks, starting in mid-March, the Fed bought almost US$2 trillion worth of assets, Treasuries and mortgage-backed securities.

Hamish

Why was the Fed so aggressive in March? US$2 trillion is an extraordinary amount to spend in such a short period of time.

Janet

The Fed found that the Treasury market was almost not functioning. And part of that reflects the fact that there were some hedge funds that had taken on huge amounts of leverage, doing trades, that are called basis trades, when they try to arbitrage out tiny differences in returns between the Treasury futures and spot markets. And these hedge funds had leverage of 50 or 100 to one.

Hamish

This sounds like Long Term Capital Management crisis of 1998 all over again. I don’t think people ever learn the history lessons from history.

Janet

That was exactly what Long Term Capital Management was about. Russia defaulted and suddenly normal pricing relationships in markets began to break down, liquidity broke down. This time it was breaking down because you had these hedge funds and reportedly also some foreign sellers of Treasuries that began massive sales of Treasuries. And the dealers weren’t able to support that, they really didn’t have the balance sheet to support it. So the Fed began to intervene in repo markets but that wasn’t enough. The Fed then opened a facility for the broker dealers to be able to borrow from the central bank. That wasn’t enough. And the Fed realised it had to go in there and buy up all that stuff the hedge funds were selling just to restore market functioning in Treasuries. It had to act because if the Treasury market doesn’t work in the US there a problem because it’s the basis of pricing in all the other financial markets. So people had to get that working. And I mean, US$2 trillion, that’s really a lot. That’s not a small amount of money. And so that was a massive intervention. 

The Fed also reactivated swap lines with foreign central banks, something it did in 2008-09 because banks all over the world that do business in dollars found themselves under pressure. Then in addition to that, the Fed saw stresses developing that looked very similar to 2008-09. There were runs on money-market funds (which also happened in 2008-09). Some changes were made but not enough. Money-market funds are allowed to put in place gates and fees if their liquidity falls. Investors began to worry that those gates might be erected and they decided let’s get out before that happens. 

I met with corporate executives who said this was the scariest thing that they had ever seen because they rely on those money-market funds to buy their commercial paper. 

They normally sell three months commercial paper but when liquidity dried up they could barely borrow overnight. Now, the Fed had figured in 2008-09 what to do to restore the functioning of money markets and the commercial paper market.

Hamish

In a way, we are very lucky that 2008-09 occurred because this sounds like a crisis of enormous magnitude and if the Fed didn’t get in front of this and very quickly, if it had waited for three or four days or even weeks, we could have had a completely different outcome in financial markets.

Janet

We would have had another Long Term Capital Management situation. We would have had a financial crisis due to runs on money-market funds. And they were also essentially runs on open-ended mutual funds, ETFs and corporate bond funds that offer daily liquidity but invest in either investment-grade or higher-yield corporate bonds or leverage loans. So we a re lucky in that way that the crisis of 2008-09 occurred. 

The Bernanke Fed had figured out how to set up facilities. Everybody had the term sheets in their drawers and they essentially pulled those out and were able to get them up and running in a matter of days. But the Fed did need support from the Treasury Department so these are not purely Fed operations; they require the consent of the Treasury and, in many cases, some fiscal backing. 

Almost every facility that was invented for 2008-09 is back in place. 

And that wasn’t enough. So the Fed did more and it was very inventive and it’s come up with new facilities. Fed officials developed facilities essentially to take the tail risk out of markets where corporations borrow and where investors invest in corporate bonds and loans on the municipal debt markets. So there’s a primary and secondary corporate-credit facility. The Fed’s out buying shares of ETFs and bundles of bonds that meet Fed criteria. It’s willing to buy bonds, new issuance of bonds of larger corporations. And the Fed’s gone even further by setting up the Main Street Lending Facility. This will take 95% of loans made by banks to businesses that are over 500 employees, but not large enough to access capital markets on their own. That’s brand-new. The Fed has never done anything like that. And the Fed’s also lending to state and municipal governments, which is a line I never thought the Fed would cross. 

I’ve had a colleague who’s advising the governor of California call me about three days before this facility was set up. She said we really need support to issue bonds, spreads have really spiked. Do you think the Fed could do anything about it? And we have a little club of former Fed people that I work with – my next door neighbour is Ben Bernanke, and Don Cone, who was a 40-year veteran of the Fed and former Fed vice chair, is next door to him. And we started e-mailing back and forth and talking about whether or not this is something the Fed would do. This can be very politically sensitive. Suppose there are defaults, does the Fed want to be in the position of taking cities in the US into bankruptcy? Certainly not. So I told her no way the Fed could do this. Two days later, the Fed announced the municipal liquidity facility. 

The Fed really pulled out all the stops and I think things have improved considerably. We’ve got a health crisis causing an economic crisis but we don’t have a financial crisis.

The economy

Hamish

Janet, a lot of people are talking about a shape of the economic recovery. Most letters of the alphabet have been mentioned. We’ve got W. We’ve got U. We’ve got V. I think we’ve got the Nike swoosh as another shape people are talking about. Do you have a view whether or not we are likely to get a V-shaped recovery or something that looks close to a V-shaped recovery? Are we likely to get a depression on the other end of the spectrum? Or is it really too difficult to call at the moment what the shape of the economic recovery will be until we know more about the virus and how long it’s going to last?

Janet

It’s highly uncertain. What happens definitely depends on the course of the virus and vaccines and treatments. But if I had to choose one of those options you gave, I would choose the swoosh rather than a V. The thing about the swoosh is that it starts off looking like a V; you have a fast collapse followed by a rapid rebound. And I think we are seeing, at least in the US, there was certainly a huge plunge, 5% negative growth in the first quarter. Most forecasters for the second quarter are looking for something in the order of negative 30% to 40% GDP growth at an annual rate. Shocking but probably May was the bottom and we’re seeing quite a few indicators suggesting an impressive recovery. There was a surprisingly positive employment report in May and also a strong rebound in consumer spending. There’s been enormous fiscal transfers and huge monetary support. And in other countries also, we’re seeing a bounce back with a lot of support. States in the US are now beginning to end their lockdowns. We’ve seen people who were on temporary unemployment spells go back to work. So it’s beginning to look V-shaped. But I opt for the swoosh because I don’t think that’s going to continue. 

I think we’re going to see solid growth in the second half of the year. But I’m expecting that over the course of the year as a whole, output in the US will decline by something in the 5% to 8% range. I think we’ll get growth after that. 

But to get back to where we started will take a number of years. 

There are a number of reasons why. One is that there’s just going to be a lot of corporate failure. There’ll be a need for social distancing for a long time. We’re beginning to see a resurgence in the US of infection. There is all too high a probability of a second wave of infections that’s going to come next fall. There’s been a lot of temporary layoffs. About 75% of people who’ve been laid off think they’re going to go back to their old jobs. They say that in surveys. But, on the other hand, 25% of people think they’re not going to go back to their old jobs. My guess is that some in the 75% group will find out that they’re not going to go back to their old jobs. And it’s just going to take a long time to get the labour market back to normal. Also there’s the issue of fiscal support. There’s been a huge amount of fiscal support in the US. There are individuals who aren’t getting it so there are pockets of pain. But on the average, unemployment compensation is very generous. The replacement ratio; namely, the share of the percentage of pre-layoff income that people are getting back averages more than 90%. For low-income workers, it’s more than 100% at this point. That’s extremely generous. There were US$1,200 cheques sent out to most individuals but there’s a fiscal cliff looming. A lot of the support ends this summer. Congress is talking about doing more but who knows what’s going to happen. So there’s a lot to retard a recovery. Thus I expect a swoosh, not a V.

Hamish

That’s very sobering, Janet, and somewhat disconnected with what the equity markets are indicating. There are 20 million Americans who are unemployed at the moment. But one of the statistics that it doesn’t pick up is the people on the pay cheque protection program. There’s a lot of medium-size and small businesses that are being paid by the government to keep their employees on their payrolls at the moment. There’s a cliff at the end of that program. And we have similar programs in Australia and they have them in the UK and Germany. So the unemployment statistics don’t tell you the real level of unemployed. A lot of these companies don’t have any intention of keeping some of these people on their payrolls once the government support disappears.

Janet

You’re absolutely right. We have lost so many jobs.

Hamish

Janet, what are the risks that most worry you at the moment?

Janet

I worry about the permanent job losses and how those people are going to get re-employed. I think that’s going to be a long, drawn-out process. I find it hard to imagine that hospitality, travel, tourism, consumer-facing sectors will come back to anything close to where they were for a very long time. So there’s going to be a lot of permanent layoffs in those sectors. Structural changes that were underway in sectors such as retail will be accelerated. I’m enjoying working from home and I know a lot of firms that have no intention of going back to their old ways of doing business. Changes are going to occur as a consequence of living through this. I’m worried about many furloughed workers, their attachment to the labour market. I think there will be people who don’t come back and are permanently sidelined. 

I’m very worried about the degree of fiscal support, which we truly need to keep the recovery going. And I don’t know if that’s going to be there. 

Hamish, what’s on your worry list?

Hamish

The first thing I would say is, Janet, there are so many known unknowns. There are so many issues that we know about but we don’t know how they’re going to play out. We don’t know the duration of this pandemic. There are so many uncertainties about the science behind the virus and heading towards a cure. We’re reopening economies I would say too early from a medical point of view. We’re seeing a resurgence, particularly in the US, and in emerging markets it appears to be out of control. 

Probably the No. 1 issue on my mind and we can talk about this is that the financial markets, because of the aggressiveness of the Fed, have literally priced in an unlimited put option to the Fed. 

They think whatever risks come up the Fed is going to be there. But there are limits to what the Fed can do, particularly in the emerging markets. You mentioned some swap lines have been put in place, it was a very inventive swap line that hasn’t been drawn down yet but it was where they could repo the Treasuries held at New York Fed. If an emerging market runs out of US dollar collateral that it could repo in order to get dollars, I imagine there’s many countries in the world the Fed is just not going to take the credit risk in a standard swap line. And if an emerging market can’t get access to dollars from the Fed and then it has to start liquidating foreign assets it might have. I think that’s near the end of the Fed’s capability to step in. There’s only so much a central bank can do. When there is an election coming up in the US around America First, I’m not sure the US is going to step in with a trillion dollars to bail out emerging markets. And there are credit risks. As we’ve talked about this, the Fed is very conscious of the high-yield markets. With the high-yield markets, if we get an acceleration in bankruptcies and real disruption, there are limits on what the Fed can do. People shouldn’t just extrapolate because the Fed’s been so aggressive that there is no downside here. There are things lurking in the dark here that you can see how these bushfires could go off here. That really worries me, that people don’t understand those smouldering fires at the moment. If some of them flare up, they will be difficult to deal with.

Janet

I completely agree with you. I expect high levels of bankruptcies and defaults. The underwriting standards on leverage loans have deteriorated enormously. I think the losses on those loans, if they default, could well be far higher than investors are accustomed to. I agree with you that there are limits to what the Fed can do to protect investors for losses. The market seems not to be fully pricing in the downside risks. With respect to emerging markets, you mentioned the new Fed facility, which was kind of an innovation and I think’s been helpful. Congress has in no way authorised the Fed to make dollar loans to emerging markets. The swap lines that we’ve had with the largest central banks have always been rationalised in terms of the importance to the US that banks around the world support American businesses. And it’s important that they have the liquidity to go on doing that. 

If the Fed were to cast it as simply a way to help other countries that are in trouble, Congress would close that off in a second. 

So the Fed’s expanded the number of central banks that they’re including in the swap lines that again they did in 2008-09. But there are limits, and I think it’s hard to imagine they’d do more. But what the Fed has done in calming financial markets has been helpful to emerging markets because they were seeing risk appetite enormous capital outflows that were putting tremendous pressure on their currencies. Now you have very low rates and spreads have come down and there’s a search for yield again. That’s indirect support for emerging markets.

Hamish

Janet, the virus is running rampant in many of these emerging markets. What happens if we get a massive capital outflow in six months’ time in these emerging markets? They will be under enormous stress. You could see another run on their currencies, even though we’re seeing dead calm at the moment and there are limits to what the Fed can do. If they run out of collateral that’s acceptable to the Fed, that’s based in the US, they’re not going to do an overnight swap line just on the basis of swapping their currency with some of these exotic emerging markets. I think you’re right. Congress would have a heart attack; that is unsecured lending.

Janet

No. I would be surprised if they went further with emerging markets. Because this crisis has been caused by a virus Congress has been very supportive of the Fed stepping in to help to keep credit flowing in a way that it was not in 2008-09. In the crisis a decade ago, a lot of people felt banks and the financial sector were responsible for what was happening. And they did not support Fed efforts to try to contain the damage to financial markets. This time, there’s a lot of support for the Fed acting, but there are still limits.

Inflation risk

Hamish

Janet, many people are focused on the scale of quantitative easing and the scale of fiscal deficits, – America’s on track for a US$4 trillion deficit this year. The Fed has already expanded its balance sheet by $3 trillion since the end of February. People say this will inevitably lead to inflation. How concerned are you about inflation and could we see higher interest rates?

Janet

I’m not at all concerned about inflation for let’s say a time horizon of two, three or four years during which the economy is recovering. 

I think we’re going to need very low interest rates for a long time. Inflation is under downward pressure. This is both a supply and demand shock. But the decline in demand, which tends to lower inflation, is much larger than the decline in supply, which creates isolated upward pressure in some sectors. And you’ve already seen, at least in the US, inflation numbers that are extremely low. So I’m not worried about inflation at all in the short term. If the economy recovers, now it gets to be a different story because we get to the point where the Fed may need to raise interest rates to stop demand from outstripping supply. And there’s nothing about the Fed having bought all those assets. Often people think, OK, they bought all those assets, trillions of dollars’ worth of assets it’ll continue. And they created all those bank reserves. And that’s money and money causes inflation. But that’s not how it works because we think of money and you know, what we’re taught in our economics classes is that money is an asset that pays no interest. But bank reserves do pay interest. They pay whatever interest the Fed decides is appropriate. At the moment, the Fed has decided zero is appropriate. But when the time comes, when higher interest rates are appropriate, that stuff you call money, those reserves that now pay zero, they’re going to pay interest. The Fed is going to raise the interest rate. They’re going to become more like debt and not like what we think of as money and it’s not going to cause inflation.

Hamish

That’s an interesting point because this is being done around the world. It’s not just the US. And there may well be some economies, it was an innovation during the financial crisis of paying interest on excess reserves, used to not pay interest on excess reserves, so that really turned this sort of excess reserves into a financial instrument. It really became a short-term Treasury or a Fed treasury maybe it would be a better description of it. But there might be countries in the world that decide they’re not going to pay any interest on their excess reserves. Is there a risk that might happen in some economies?

Janet

I believe that’s more of a political question than it is an economic question. Independent central banks with inflation mandates, when they see that higher interest rates are needed to contain inflation, they raise interest rates. That’s usually the end of the inflation risk. But the political angle comes in because we’re going to have an enormous federal debt. And when the Fed decides to raise interest rates, that’s going to increase the interest burden on that debt. And it’s going to begin to put some real pressure on the government budget. And the government will have to raise taxes, cut spending, do painful things as interest payments get larger. At the moment, interest payments are very, very low and they’re going to stay low as long as interest rates are low.

Hamish

Do you think central banks can lift interest rates to put the brakes on the economy when higher interest rates will make it harder for governments to cope with their debts?

Janet

If central banks start raising interest rates it has an impact on fiscal policy. It has to become more contractionary. And if that happens, it means that there’s less need to raise them to very high levels. But we’re generally very worried about secular stagnation, weak spending in the economy, a lot of saving, weak investment; an environment in which there would be a prolonged reason for interest rates to stay low. Low inflation – too low inflation. And I think the pandemic has just intensified that problem. 

So I don’t think we’re going to go back to a world anytime soon where interest rates need to be high to contain inflation. But life is uncertain. 

Sometimes central banks lose their independence when the government decides they’ve really got problems and they’ve got to go to that agency down the street that forced it to hold interest rates low and buy the debt the government issues. That’s how you end up with very high or hyperinflation. I don’t think that’s going to happen in the US.

Hamish

Janet, if people have been listening, they might be a bit depressed at the conversation so far. But it’s not all negative in terms of what’s going on in the economy. If you take a longer-term view, what are the things that that you’re most optimistic about at the moment?

Janet

I’m optimistic about progress on vaccines and treatments. We’ve got a very inventive scientific community that’s very hard at work. What I hear about vaccine development is very positive. And so conceivably late this year, early next year, we’ll have vaccines that are going into production. I’ve been pleased that Congress and the administration have supported a very active role for fiscal policy. I’m worried about what’s going to happen this summer, but I’m optimistic that there will be continued support and we do have an election coming up and I’m hopeful that we will come out of that with a renewed willingness to address some of these problems, and a more organised strategy. Hamish, what are you optimistic about?

Hamish

I’m optimistic about humanity and progress of humanity. You look what’s happened in this world in the past 200 years. We are speaking on a computer at the other end of the world. How did this happen? That is the progress of humanity here. You talk optimistically about a vaccine. In the next 20 to 50 years, we will make enormous progress in medical science for the benefit of humanity. I’m optimistic around the technological advancements we’re seeing in the in the world and the benefit that that can do for humanity. I’m optimistic that human progress will solve climate change, even though we feel like it’s never going to be solved. But I’m optimistic that humanity will solve this. 

I’m very optimistic what humans can do with our intelligence and our collective power. I’m pretty optimistic that if I take a 10-year view, things are going to turn out pretty well. 

But in the next 12 to 18 months, it’s incredibly uncertain. I don’t want to mislead people about the uncertainty. But if you take a longer-term view, think about the progress humanity keeps making.

Janet

As you think about this in terms of portfolio and investment strategy, is your focus on the long term or do you see a need to position yourself for the shorter term given what’s happening?

Hamish

At the moment, we’re running a very conservative position in the portfolios. We’re holding a lot of cash. We’re very underweight emerging markets in the portfolio. But at the same time, we’ve got some very large positions in large technology-enabled growth companies. So while we’re being conservative in the short term, we’ve got our eye on where the bull’s going in the longer term. We’re keeping investments that are very advantaged in the long term and supported by technological and, actually, changes that are happening at the moment. This crisis is accelerating some behaviours and trends that were already happening. I’m optimistic that this work from home environment will lead to a better work-life balance for many, many people. And it would have never happened without this crisis because business wouldn’t have taken the risk to try it because everyone would have been sceptical about it.

Janet

I agree with you. I think people have been really surprised at just how well it’s working. And a lot of technology is developed around that.

Hamish

Well, Janet, we may wrap it up. Firstly, on behalf of Magellan, thank you so much. That was incredibly comprehensive to get all your

Janet

The same to you Hamish, stay safe.

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