“Everything that happens once can never happen again. But everything that happens twice will surely happen a third time.” — Paulo Coelho, The Alchemist
From the Wall Street Journal:
“The ECB lowered the interest rate on an existing program of cheap loans it offers banks, known as targeted longer-term refinancing operations, or TLTROs. Banks that lend enough money to customers will be able to borrow from the ECB at a rate of minus 1%, starting in June. In other words, the ECB will pay them 1% to borrow money. Lenders that don’t meet the threshold will still be able to borrow at minus 0.5%.”
The European Central Bank is adjusting its operations to counteract the negative impact of negative interest rates on the profitability of European banks. As the central bank engages in quantitative easing, it swaps bonds held by banks with cash, or more accurately with reserves held at the ECB. European banks now have higher levels of cash but said cash ‘earns’ a negative return thereby eating into the profits of the banks.
The easier solution might be to not have negative interest rates ¯\_(ツ)_/¯.
From the Financial Times:
“Jay Powell sent an unmistakable message to investors and the public on Wednesday: hopes for a quick economic rebound in the second half of the year risked being an illusion and the Federal Reserve was gearing up for a long fight against the effects of the coronavirus pandemic.”
Given the convulsions negative rates have caused for European banks, it is unlikely the Fed’s ‘long fight’ will involve the introduction of negative rates in the US.
From the Bloomberg:
“The SNB seems to have injected billions of francs into the foreign exchange market last week in data showing a jump in the amount of cash commercial banks are holding, after the coronavirus fallout drove up the haven currency. The franc reached 1.0612 per euro on Tuesday — the Swiss currency’s weakest level since March 31.”
The Swiss National Bank (SNB), Switzerland’s central bank, continues to buy billions upon billion of euros to avert a strengthening Swiss franc and the deflationary impulse that comes with it. The SNB might be the single biggest factor that the euro is not at the parity with the US dollar.
Clearly, we are living in times when central bank actions appear to be unprecedented. Rather than argue that ‘unprecedented’ central bank intervention is the precedent during financial crises, we share, at the end of this piece, a long passage about the Bank of England’s response to a financial crisis caused by the collapse of Overend, Gurney & Co. in 1866 from Neil Irwin’s The Alchemists: Three Central Bankers and a World on Fire.
Moving on.
Tactical Thoughts: Caution is Warranted
April was a good month for the US stock market. Stocks bounced back sharply, retracing a fair chunk of the draw down from February and March. Despite the rebound, only the information technology sector is in the green for year; although the healthcare sector too was in the green for the year until earlier this week.
The above chart is the year-to-date total return performance by sector of the constituents of the S&P 500 Index.
As we look through the market and combine it with the Fed having shown its hand this week, the odds of another leg lower in market in the near term seem better than even. Tactically, it is a good time to increase cash levels and take profits on some of the sharp gains accrued in April.
To clarify our thinking, below are some charts with minimal comments that have caught our attention.
Starting with $SPY as a proxy for the S&P 500 Index, the broader market has retraced the COVID-19 driven sell-off to the 61.8% Fibonacci level.
Healthcare, using $XLV, has filled the gap created during the sharp sell off in markets that began in February. More importantly, the sector has stalled and seen some of the leading names stalls after filling the gap despite the positive soundbites about potential treatments for the coronavirus.
As an example, Vertex Pharmaceuticals $VRTX, one of the leaders in the healthcare space, has witnessed a sharp pull back after having broken out to all-time highs.
Even though COVID-19 cases are still rising in the US, positive news relating to potential remedies, such as Gilead’s remdesivir, and prospects of states coming out of lockdown have buoyed markets. Unless there is meaningfully positive news about a vaccine, healthcare names appear susceptible to a sharp pullback.
Technology, using $XLK, has retraced above the 61.8% Fibonacci level.
Amazon $AMZN appears stretched while momentum — bottom panel, measured using 12 week change in price — is stalling, creating a negative divergence. Generally, a turn in momentum has been a good short-term indicator to take profits in $AMZN.
The Alchemists
After the Overend collapse, savers all over Britain didn’t know which institution they could trust. Would their bank be next? They had no idea, so they thought it safest to withdraw their money and wait out the storm. But this very act makes the failure of more banks that much more likely. No bank has the cash on hand to pay off withdrawals if everybody wants to pull their deposits out at the same time. The institution must try to sell off whatever it can to come up with the money—in Overend & Gurney’s case, bills of exchange. As more bills were dumped onto the market, their price fell, meaning that even sound banks ended up incurring a loss—which made their depositors all the more eager to withdraw their funds.
The details may vary, but this type of vicious cycle is at the core of any financial panic, whether in 1866 or 1929 or 2008. If not stopped, it can shutter businesses on mass scale and wipe out the savings of a nation. In any case, it has a psychological effect. As Bagehot described it, “The peculiar essence of our banking system is an unprecedented trust between man and man. And when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.”
On Threadneedle Street, the leaders of the Bank of England viewed it as their job to stop that cycle cold. Their goal in such situations wasn’t to act like private bankers, hoarding cash for themselves, but to prevent the banking system as a whole from shutting down. On the morning of Black Friday, May 11, 1866, the bankers of London lined up at the Bank of England’s Discount Office. “The bankers accustomed to pledge their securities with Overend and Gurney went wild with fright,” according to one contemporary account, “besieged the Bank of England and the Chancellor of the Exchequer, and communicated their apprehensions to the public…for four or five hours it was believed that half the banks in London would fail.” Bank governor Henry Lancelot Holland had to decide whether to fulfil the demands for liquidity—which would mean exposing his institution to far greater risk than it had taken in the past.
His decision was, in effect, to extend credit as far as the eye could see, and damn the naysayers—and there were naysayers, including on the Court of the Bank of England, the equivalent of its board of directors. The strategy was, at its core, simple: If a banker or broker or trader had a bill or other security that would be valuable in a time the markets were functioning normally, it could be pledged at the Bank of England for short-term cash—but with a “haircut,” or a discount on what it was thought to be truly worth. “Every gentleman who came here with adequate security was liberally dealt with,” Holland said later.
It was essentially using the ability of the Bank of England to issue pounds as a barrier against the further spread of the crisis. Holland had to receive special permission from the chancellor of the exchequer, William Gladstone, to £4 million in credit. Over the ensuing three months, £45 million was extended, “by every possible means…and in modes which we had never adopted.” Recall that this was a time when all the bank deposits in Britain totaled around £90 million. Relative to the size of the British economy at the time, it would have been the equivalent of the Federal Reserve extending about $3.5 trillion in the aftermath of the 2008 Lehman Brothers crisis.
The panic gradually subsided, preventing the economic ruin of an empire. Months later, Holland described the Bank of England’s actions this way: “Banking is a very peculiar business, and it depends so much upon credit that the very least blast of suspicion is sufficient to sweep away, as it were, the harvest of a whole year…This house exerted itself to the utmost—and exerted itself most successfully—to meet the crisis. We did not flinch in our post.”
From these events, Baegot drew a series of lessons now known as Bagehot’s dictum. In a panic, he wrote, a central bank must take its resources and “advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good.”
The shorthand version, familiar to all present-day central bankers, is this: Lend freely, on good collateral, and, as Bagehot also specified, charge a penalty interest rate, “that no one may borrow out of idle precaution without paying well for it.” It’s a simple guideline, but a powerful one. The central bank should open its doors, and its vaults, using its vast stores of the one thing in demand—cash—to stop that vicious cycle. And it should lend only on good collateral, which is to say, against securities whose values have been depressed only by the atmosphere of panic, not by fundamental. However, the bank should charge a high enough interest rate on these loans that borrower don’t take unjustified advantage of them.
But there are a couple of other lessons from the collapse of Overend & Gurney that don’t fit neatly into Bagehot’s dictum. First, even if a central bank moves aggressively to stop a financial panic, it may still not be enough to prevent a nasty economic downturn. Because the Bank of England’s lending during the panic was directed only at firms that were illiquid—and thus was little good for that there insolvent—plenty of banks failed besides Overend: the Bank of London, Consolidated Bank, the British Bank of California. And whenever banks fail and credit tightens, businesses of all types are forced to pull back on their activity: The London, Chatham and Dover Railway was building major rail lines in Canada and the Crimea financed by bills of exchange when Overend & Gurney went under. The projects collapsed following the tightening of credit. The funding for a rail line under the Thames evaporated as well.
With no lending available, ironworkers and coal miners and shipbuilders and others who depended on business expansion to make a living found themselves out of work on a mass scale. Economic statistics for this era are unreliable, but estimates by a trade union put the UK unemployment rate at 2.6 percent in 1866, and at 6.3 percent in 1867 after the credit freeze.
A second lesson of the Overend & Gurney crisis is that when a central bank intervenes on massive scale to stop a panic, it does so at its political peril. In the aftermath, the ire of a nation was directed at the Bank of England. An institution with public backing had, after all, done a great favor to wealthy bankers whose bets had gone sour. And the economy—the conditions faced by the masses of workers and merchants—were terrible anyway. The Times editorialized that the bank had saved firms that were unworthy, that it had “mulcted for the unthrifty,” and, invoking the biblical parable of the ten virgins, that “the foolish virgins made so much clamour they compelled the wise virgins to share their carefully collected oil.”
Some of the hand-wringing came from Threadneedle Street itself: Many of the Bank of England’s directors were aghast at what Governor Holland had done in the crisis. Thomson Hankey, a director on the Court of the Bank of England, wrote that the idea of the central bank acting as a lander of last resort was “the most mischievous doctrine ever broached in the monetary or banking world in this country; viz, that is the proper function of the Bank of England to keep money at all times to supply the demands of bankers who have rendered their own assets unavailable.” Although the bank had secured the blessing of the chancellor of the exchequer, its actions during the crisis were undertaken without formal legal authority. Legislation to empower the bank to play such a role in the future went nowhere in Parliament.
A century and a half later, Ben Bernanke & Co. would discover once again that lending freely to “this mand and that man” may be the best course of action in a financial panic—but that not all men will approve.
(Emphasis added.)
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
