Ambrogio Cesa-Bianchi and Fernando Eguren-Martin
In March 2020, the Covid-19 (Covid) epidemic shook the world. With economies virtually closed, financial markets were an exception and have remained open. However, it was not as usual for them: the increased need to face immediate obligations, and a more widespread increase in risk aversion, led investors to liquidate their positions in favor of the old money. In a recent staff discussion paper, we argue that investors weren’t looking for any kind of liquidity, but rather that the world has witnessed a ‘rush for dollars’. We show that the resulting dollar rush overtook currency markets and led to selling pressure on dollar bonds in corporate bond markets, which saw particularly large increases in spreads.
The main objective of our research is to exploit the heterogeneous spread dynamics between corporate bonds to learn more about the nature of the underlying shock that hits the financial markets during the Covid turmoil, as well as its mechanism of transmission. We analyze the evolution of spreads from a large global dataset of corporate bonds issued by more than 2,000 companies in more than 50 countries. In particular, we link the dynamics of these bond spreads during the month of March 2020 to their underlying characteristics, in particular their maturity and their currency of denomination. Importantly, by focusing on within-firm variation, we are able to avoid selection issues that would arise if firms of a certain type tend to issue bonds with certain characteristics.
We analyze the evolution of spreads between the end of February, when market conditions were still relatively calm, and March 20, at the height of the tensions and just before the intervention of the Federal Reserve in the corporate bond markets. . Three main results emerge. First, for dollar bonds, spreads widened further on short maturities, in line with previous findings. One possible interpretation of this result is that the markets experienced a ‘money rush’, in which investors in need of liquidity began by selling their most liquid assets in order to minimize losses from the fires – generating what one called a ‘hierarchical order of liquidity’. Since short-term bonds tend to be more liquid, selling pressures could put downward pressure on their prices (upward pressure on their spreads), which could explain our first finding.
Second, the spreads of dollar bonds have increased more than those of non-dollar bonds, regardless of their maturity. This observation could be further rationalized by the hierarchical order of the liquidity mechanism presented above. Liquidity is a defining characteristic of an international currency such as the US dollar. Thus, it is possible that investors sold their liquid assets in dollars first, putting downward pressure on their prices relative to non-dollar assets.
However, third, we also find that for bonds other than the dollar, it is the spreads of long-term bonds that have seen the largest increases. This reversal of the relationship between maturity and bond spreads (relative to the dollar sample) is at odds with a general trend of selling liquid assets in cash. In fact, one would expect more liquid short-term bonds to be subject to greater selling pressure (i.e. a larger increase in spreads) for each currency taken in isolation. Something else must be happening.
What can explain our empirical results? Our interpretation is that the world has not seen a race for money in general, but a “race for dollars” in particular. Investors did not sell dollar assets because of their superior liquidity but because of the need to obtain dollars in cash, for reasons that ultimately relate to the role of the US dollar as the dominant currency in the market. international monetary and financial system.
Two important characteristics of the dollar’s dominance could be linked to our findings. First, the US dollar is the most widely used currency for international securities issuance and cross-border banking, as well as for portfolios of international investors. The dominance of the dollar therefore implies that, overall, a greater share of balance sheets is denominated in US dollars than in any other (non-domestic) currency. This, in turn, means that agents may face more obligations to fulfill in US dollars than in other foreign currencies. If these obligations were to be suddenly fulfilled (or, similarly, if the likelihood of having to fulfill these obligations in the near future increases), a demand for dollars in cash would arise. Another defining characteristic of a dominant currency is its perceived security, which arises from the fact that it provides natural hedging in times of crisis. While agents in need of precautionary liquidity have a choice of securing liquidity in dollars or other currencies, they might choose to do so in dollars as the US dollar tends to appreciate in times of crisis (i.e. that is, it is a so-called safe haven currency).
To further corroborate our interpretation, as well as its generality beyond the Covid episode, we perform an additional exercise exploiting the dynamics of spreads around another period of stress in financial markets, namely the global financial crisis. Although less ubiquitous than today, the dollar still played a dominant role in 2008. If our interpretation is correct, we should therefore observe dynamics similar to those obtained during the Covid period. Indeed, we find that our results hold around the Lehman collapse, confirming the interpretation of the dollar dash and suggesting that it could be a more general characteristic prevalent during times of stress.
In summary, we show that the denomination currency is a key variable to explain the heterogeneity of corporate spreads in times of stress. In particular, the role of the US dollar in explaining the dynamics of corporate spreads testifies to its status as the dominant currency in the international monetary and financial system. What lessons can decision-makers draw from our conclusions? A dollar rush can affect the financial stability of the balance sheets of investors with US dollar assets and companies with US dollar liabilities. For example, investors whose holdings favor US dollar-denominated assets may experience greater losses than not during times of stress. In turn, companies with financing needs would have to pay higher prices for financing if they issue bonds in US dollars (usually to meet investor demand). Additionally, this characteristic of US dollar-denominated corporate bonds could affect their price outside of times of crisis, as investors tend to demand higher risk premiums for holding assets that lose value during times of crisis. “Bad”. The supply of US dollars abroad by the Federal Reserve in times of crisis, including through the expansion of its network of central bank swap lines, shows that these issues are indeed part of the body of concerns being addressed. consideration by policy makers.
Ambrogio Cesa-Bianchi and Fernando Eguren-Martin work within the Bank’s Global Analysis Division.
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