The Fed Goes All In: What It All Means and How It Will Shape the Markets

On Sunday, the U.S. Federal Reserve went all in. They cut their target rate to zero, reignited QE purchases in earnest, and implemented a number of other measures aimed at improving liquidity and overall functioning of financial markets. A couple of hours later U.S. stock futures were limit down, indicating that the Fed's actions were clearly not enough. Here are my thoughts on what the Fed's moves might achieve, what they will do next, and how it will shape markets in the coming days. Illiquidity Is a Major Problem, but Obviously Not THE Problem THE problem facing markets is the sharp downturn in economic activity that will result from social distancing. This includes lost revenue for businesses such as restaurants, hotels, transportation, etc. It also includes the effect of lost wages for many who work in those industries. Some commentators are saying that fear is our enemy here. It is actually the opposite. There is very little the Fed can do to help recover that revenue. I hear some commentators saying that fear is our enemy here. It is actually the opposite. Fearing the virus and staying home is the best thing we can do, but it will have a disastrous economic impact. However, the fact that the Fed can't solve this problem doesn't eliminate their role entirely. Markets have become extremely illiquid in the last week, especially bonds, options and smaller cap stocks. Since I'm a bond guy I'll use fixed-income examples. In Treasury bonds, the bid/ask is usually quoted between 1/64 and 1/32 of a point. Usually, in reality, it is even less once you engage with Wall Street trading desks. On Friday, some long-term bonds had a bid/ask of 1 point. That's equivalent to where higher-quality high-yield bond bid/asks usually are. Another example is municipal bonds. Munis are usually the most staid of the major bond sectors, but over a four-day period from Monday to Thursday, AAA muni yields rose 100 basis points even as Treasury yields fell. The culprit seemed to be some routine outflows at large mutual fund complexes. Normally Wall Street banks would buy the bonds from the sellers, mark them up and sell them at a profit to other buyers when the outflows subsided. Last week Wall Street refused to participate, forcing the sellers to fire sale the bonds. Alleviating illiquidity is central banking 101 stuff. It isn't the Fed's job to prevent volatility, but it is the Fed's job to keep markets functioning. Something Is Wrong With Banks Why have these markets become so illiquid? We don't know for sure what the underlying cause is, but for some reason, Wall Street banks are unwilling to pledge capital to market making. Why not? Usually when there is money to be made, Wall Street is more than happy to make it. In this case there is definitely plenty of money to be made, including in very low risk markets like munis, but the banks are nowhere to be seen. I am loath to speculate about what is going on with bank capital. We know during periods of volatility, traders tend to have their limits tightened by risk managers. I don't think that can explain all of what's going on, though. I never saw Treasury bid/ask spreads blow out like this, even in 2008. I think at least part of the issue is that capital is being used up elsewhere at the bank. We know that companies are pulling down lines of credit, trying to protect their own liquidity. It is also likely that banks are anticipating loan losses increasing, which reduces the amount of capital the bank has available. It is also true that bank balance sheets are less fluid than they once were. Dodd/Frank rules prevent them from ramping up leverage opportunistically. So, for better or for worse, we have created a system where economic weakness and market illiquidity are more closely tied than before. It also seems that there are some stressed sellers, at least in the Treasury market. We have seen erratic sellers of very long-term bonds putting heavy pressure on that part of the market. On Thursday, the worst day for stocks in 33 years, long-term Treasury bonds finished lower in price, and appeared to be highly correlated with the move in stocks intra-day. My best guess is that there's a foreign holder who is desperate for U.S. dollars, and doesn't have access to lending lines in the right currency. Therefore, they are selling whatever dollar assets they have. How Will the Fed's Actions Help? The Fed's set of responses on Sunday are aimed at alleviating all of the problems I've detailed above. Whether they will be enough remains to be seen, but here's how they might help. QE: If there is a major foreign seller of Treasuries, the Fed can soak up that selling themselves. This will also alleviate pressure on Primary Dealers to take down Treasury auctions on balance sheet. Don't worry about the buffers: The Fed advised banks that they should use their liquidity and capital buffers to expand lending. In other words, don't worry about having an extra cushion right now, the Fed's got your back. Discount rate cut: The Fed eliminated the penalty rate for using the discount window. That rate is now 0.25% also, and those loans can now be taken for up to 90 days. I think this is basically telling banks that if you use your liquidity buffer to make loans and are surprised by customer withdrawals on a given day, use the window. Don't stop lending. Reserve requirements: The Fed has eliminated all reserve requirements (not capital requirements, as some on Twitter seemed to think). This is honestly more symbolic than anything. The system is flush with reserves, so the reserve requirement hasn't been a meaningful constraint in a decade. So I think this is the Fed's way of really driving the point home that they mean it. Please keep lending! What Comes Next for the Fed? I do not believe the Fed is done. However, most of what they will do going forward will be addressing market functioning, and will have only minor (or secondary) effects on the real economy. The most prominent thing that I expect to come soon is putting caps on particular Treasury bonds. For example, saying that the Fed would buy 2-year notes until the yield was 0.10% or less. Fed Governor Lael Brainard has discussed this ideal several times, most recently in a Feb. 21 speech. Vice Chair Richard Clarida also endorsed this idea. Fed communication like this doesn't come out of the clear blue sky. This is purposeful communication to markets. So, I'd expect the Fed to target 2-5 year bonds at some lower rate in the near-term. This would probably take the place of the QE program growing, because they'd essentially pledge as much QE as needed to keep their targeted bonds below the stated cap. Another likely action is expanding QE to other types of bonds. Powell said in his press conference that they aren't considering this right now, but could in the future. The obvious candidate right now is munis, which wouldn't be as controversial as buying private assets such as corporate bonds. I would think if munis are still rioting a week from now, the Fed might step in, especially if new issues become hard to bring. The Fed could change its monetary regime entirely. Next is some kind of funds for lending program. The U.K. and the eurozone have used such programs already. This is where the Fed makes money available to banks at some extremely cheap level (probably a negative rate) with the provision that the money has to be lent out. Further stipulations can be made, such as it has to go to smaller businesses, firms spending on real business expansion (not M&A or dividends), or consumers. Lastly, the Fed could change its monetary regime entirely. There is a growing consensus within academia that some version of level targeting would be superior to the current inflation targeting strategy. Under level targeting, you don't target an annual rate of growth but a level over time. For example, under inflation level targeting, you'd target 2% growth in prices over time. Hence, if in one year inflation is only 1%, the central bank would try to increase inflation above 2% in subsequent years to make up for the short-fall. Think of it as targeting an average inflation rate over time instead of just the rate in any given year. A change like this would not require Congress to change the Fed's formal mandate, since the Fed has the freedom to pursue price stability and full employment, however they define it. I'd say the yield cap is very likely, and will be coming soon. Buying other types of bonds under the QE program is extremely likely but only if there are acute dislocations. The other two possibilities may only become likely if conditions continue to deteriorate. The Fed is flying blind here, along with the rest of us. We won't know much about how deep a slowdown we are facing until some hard data comes out, and that will take time.

The Fed Goes All In: What It All Means and How It Will Shape the Markets

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