Coronavirus: A Hollywood Ending?

The Fed can buy all the assets they want, but it won't make any company or individual consume goods or services.

This is the fourth post in my coronavirus blog series.

Like most Americans, when I heard that theFederal Reserve were going to buy CLO's, municipal bonds, and junk bonds, Iimmediately took the whole family out for a huge meal at our favoriterestaurant, bought a new washer and drier, pulled the trigger on redoing thekitchen, and booked a five-star vacation in Turks & Caicos.

Of course, I did none of those things.  And I won't do any of those things for atleast another year. 

And neither will anyone else.

The Federal Reserve Board, a group of unelectedofficials, who run an unaudited bank, have, in their wisdom, decided to buyspeculative investments during the worst economic event in living memory andquite possibly in our country's history.

Spoiler Alert: They're doing it with yourmoney, and all on leverage.

As outrageous as all this socialism for therich is, the real crime is that it doesn't solve the problem at hand.

We are in the greatest demand shock since theRenaissance. The Fed’s asset purchases do nothing to create demand for goods andservices.  Indeed, the linkages betweenasset prices and the real economy are very low, typically about 4.5 percent.[1]  This means that a dollar increase in assetprices only leads to 4.5 cents of incremental consumer spending.[2]

In the time of coronavirus, any asset priceconsumption linkages will be negative, as consumers see all their assetsdepreciate simultaneously.  For instance,Federal Reserve asset buying will not increase real estate prices.  Indeed,economist Danielle DiMartino Booth is predicting another 35 percent decline inhome prices, which was last experienced during the Global Financial Crisis (“GFC”).[3]

In short, the Fed can buy all the assets theywant, but it won't make any company or individual consume goods or services.  Did you, dear reader, buy anything onthat news?  If not, when will you?  Your answers should give you deep insightinto the efficacy of the Fed’s maneuvers and the fate of the U.S. economy.

The Obscene Outcomes of Socialism for the Rich

Taken to its logical conclusion, FederalReserve asset purchases will lead to some extremely perverse and obscene results.

For instance, you could have junk bonds tradingat par when the issuing firms go bankrupt.

Take a moment to think this through.  This will mean that the speculators (who voluntarilyfinanced firms that leveraged themselves to the point of insolvency) will havebeen bailed out by the U.S. taxpayer. 

Not only bailed out, but profited handsomely,because the speculators will have earned all the interest on the junkbonds they bought, and received all their principal back, because thetaxpayer took them out of their positions.

The taxpayer, in turn, will be left with aportfolio of defaulted junk bonds, purchased at par, that should rightly betrading at 20-30 cents on the dollar.

This is socialism for the rich.  The taxpayer gets the risk and the speculatorgets the reward.

If this all sounds far-fetched, look at whatthe corporate bond markets did on Thursday after the Fed announced their newjunk bond purchasing policy.  (Infairness, they did also promise to purchase CLOs, which are comprised of speculativecorporate loans.)

Chart 1: iShares iBoxx Investment Grade Corporate Bond ETF[4]

bantam inc jack duval multi-family office new york manhattan - lqd

Chart 2: iShares iBoxx High Yield (“Junk”) Corporate Bond ETF v. Indicative Value[5]

bantam inc jack duval multi-family office new york manhattan - hyg v. hygiv

In Chart 2, above, it can be seen that the HYGjunk bond ETF price (the white line, top pane) is now trading over four percentabove its Net Asset Value (the green line, top pane).  The premium can be seen in the red line inthe bottom pane.  Put another way, theFed action has caused investors to not only pile into speculative bonds, but topay a premium to what those bonds are actually trading at individually.

Extreme Hoarders

The Fed liquidity injections via a mania of acronymprograms has stopped the run on cash as everyone sold in the initial coronaviruspanic.  This is a problem we have knownhow to solve for some 100 years.  In short, the Fed served as lender of lastresort to all the various credit markets that seized up when everyone hit theexit at the same time.


Again, these action do nothing for thereal economy and the collapse in demand. They only stopped the liquidity crisis.  No one is leaving their house because thebid-ask spread for treasuries came in.

What money is in the system is being hoarded byall players, including banks, corporations, and individuals.

This will be seen in the velocity of money,which measures the number of times a dollar gets spent in the economy.  Thevelocity of money will almost certainly collapse, accelerating its long-termtrend down.

Chart 3: Velocity of M1[6]

bantam inc jack duval multi-family office new york manhattan - m1 velocity

The velocity of M1, which is actual physicalmoney, has been in a steep decline for over a decade.  The coronavirus could well put an end tophysical money.  Why use physical cash iftouching it can kill you?  (This isanother good argument for cryptocurrencies, which I will have more on insubsequent posts.)

Chart 4:  Velocity of M2[7]

bantam inc jack duval multi-family office new york manhattan - m2 velocity

The velocity of M2, which is M1 plus cash and checkingdeposits and money market funds, is also on the decline and will also likelycollapse as entities and individuals hold onto cash for dear life.

This is what happens in a demand shock.  Instead of spending money, it gets hoarded inaccounts, wallets, and cookie jars.  The result is that those who need money can'tget it and they have to sell assets to meet their liabilities.

The selling part is known as debt deflation, firstdescribed by Irving Fisher and then perfected by Hyman Minsky, and is whatneeds to happen if we are to ever have a healthy economy again.[8]

Chart 5: Commercial and Industrial Loans v. Default Rate[9]

bantam inc jack duval multi-family office new york manhattan -  c&i loans v. defaults

In Chart 5, above, Total U.S. Commercial andIndustrial Loans (white line, right axis) have grown to all-time highs, whiledefaults on those loans (red line, left axis) are near all-time lows.  In the past three down-cycles, loans havedeclined by roughly 20 to 40 percent, and loan defaults have increased byroughly two to four times.  I wouldexpect loan defaults to increase by at least five times from the currentlevels.

The Hysteresis of Low Consumption

"Hysteresis" is a word that economicsstole from physics.

The literal translation from the Ancient Greekis: to occur after; later; to be behind; and deficiency or need.[10]

In economics, hysteresis is the well studied phenomenonthat after a certain state as been achieved and remains for a while, it tendsto continue. This is known in the old adage that "nothing succeeds likesuccess".  Unfortunately, theopposite is true as well.

Hysteresis is frequently used to explain howunemployment in certain places, such as Europe, becomes persistent and resistschange from policy responses.  It is how certain economic states of beingbecome "structural", or baked into the cake.

The U.S. (and most of the world) is undergoingan employment shock.  Twenty percent, ormore, of U.S. workers could become unemployed and many of them will remain thatway for at least a year.

Hysteresis tell us that this may result in apermanently higher level of unemployment.

Why?  First,any recovery will take time, primarily because people are unwilling to die fromeating out, seeing a movie, or getting on an airplane; second, some workerswill become discouraged and give up looking for new jobs; and third, firms willrealize that computers don't get the coronavirus and look to replace humanswhere possible.

All of these effects will be realized tovarying degrees.

However, I am more interested in anotherhysteresis effect, that of consumption.

Irrespective of how long the quarantines andself-isolations last, consumers will have learned something that many of themdid not know before:  they can get alongjust fine without spending money and they can do it for a relatively long time.

These revelations may come as a surprise tothose at the top of the income distribution. (The further down the income distribution someone is, the more theyalready knew this.). However, the top of the income distribution is absolutelycritical to aggregate demand because everyone else is broke.  Now even the top of the distribution isfeeling broke.

This is a key weakness of the leveragedpost-GFC economy.  Ominously, itparallels the exact conditions at the start of the Great Depression.  In Galbraith’s brilliant accounting of theGreat Depression, he wrote: [11]

There seems little question that in 1929… the economy was fundamentally unsound.  This is a circumstance of first rate importance.  Many things were wrong, but five weaknesses seem to have had an especially intimate bearing on the ensuing disaster.  They are:

(Number one) The bad distribution of income.  In 1929 the rich were indubitably rich.  The figures are not entirely satisfactory, but it seems certain that the five percent of the population with the highest incomes in that year received approximately one-third of all personal income…

This highly unequal income distribution meant that the economy was dependent on a high level of investment or a high level of luxury consumer spending or both… Both investment and luxury spending are subject, inevitably, to more erratic influences and to wider fluctuations than the bread and rent outlays of the $25-a-week workman.

Income inequality is very likely worse now.  For instance, in 2016 the top one percent of income earners received 16 percent of all income and the top 20 percent of all income earners received 55 percent of all income.[12]

Consumers learning a new steady state of lowconsumption is not good for the economic recovery, whenever it comes.  Indeed,our whole economy is geared around consumers disbelieving that they can behappy without all the goods and services they see advertised on TV.

Furthermore, the world is going through atraumatic event and will have collective PTSD when it’s over.  Shell shocked people don’t make for goodconsumers.

As I wrote about in my previous post, post-coronavirus the whole world is going to embark on a balance sheet rebuilding exercise.  As Keynes taught us with “the paradox of thrift”, savings comes at the cost of demand.

Which brings me to the stock market.

The Grinder

The “Crash of 1929” actually lasted close tothree years.  There was an initial panic,when the stock market declined 43 percent, then a roughly five-month reliefrally of 46 percent, and then a grinding decline from the failed rebound of 83percent.

As I wrote in my last post, there were many rallies during the last leg of the decline, and they all should have been sold.

Chart 6: S&P 500 2020 v. 1929 Comparison[13]

bantam inc jack duval multi-family office new york manhattan - spx 20 v. 29 with annotations

In Chart 6, above, the blue line is the priceof the S&P 500 beginning on October 11, 1029 and the white line is theS&P 500 beginning on February 20, 2020. They have a very similar pattern with both exhibiting a sharp selloffand then a sharp recovery.

I believe the current market will alsoexperience the grinding decline after the current relief rally fails.  I am not predicting an 83 percent declinefrom that point, although that has a non-trivial probability at this point.  (If we have a coronavirus relapse inNovember, then it becomes likely.)

Instead, I believe the market will decline atleast 50 percent from its all-time high, undergoing a grinding decline thatwill break the hearts and finances of those who have been convinced to “buy andhope”.

How far this grinding decline goes is the onlyreal economic and financial question. Ask yourself:  how can we have globaldepression-level economic data and a blink-and-you-missed-it stock marketdecline?

Do we get the Hollywood ending, where Jerome Powell rides to the rescue, saving all of us pilgrims from the ravages of debt deflation and insolvencies?  Don’t bet on it.  You don’t unwind 11 years of a wanton debt orgy in two months.  Two years is much more standard.

[1]      Moody’s; “Weighing the Wealth Effect”; Mark Zandi.  Available at:; Accessed April 10, 2020.

[2]      If the rationale is for liquidity in the junk bond market, it is misguided.  Just because bond spreads are wide doesn’t mean the market is illiquid.  It just means that buyers are willing to provide liquidity at lower prices.  This is how markets are supposed to work.

[3]      Bloomberg; “Another U.S.-Wide Housing Slump is Coming”; Danielle DiMartino Booth; Available at:; Accessed April 10, 2020.

[4]      Source:  Bloomberg.

[5]      Source:  Bloomberg.

[6]      Source:  Bloomberg.

[7]      Source:  Bloomberg.

[8]      See Wikipedia; s.v. “debt deflation”.  Available at:; Accessed April 15, 2020.

[9]      Source:  Bloomberg.

[10]     An Intermediate Greek-English Lexicon; Liddell and Scott; Oxford University Press; s.v. hysteresis.

[11]     John Kenneth Galbraith; The Great Crash: 1929; Houghton Mifflin Company; Boston; 1997; 177-8.

[12]     Chad Stone, Danilo Trisi, Arloc Sherman, and Jennifer Beltran;  “A guide to Statistics on Historical Trends in Income Inequality; Center of Budget and Policy Priorities; January 13, 2020.  Available at: Center of Budget and Policy Priorities; Accessed April 16, 2020.

[13]     Source:  Bloomberg.


Jack Duval

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