Now, It's Fed Unlimited

Early Monday, the U.S. Federal Reserve announced a slew of new programs aimed primarily at improving liquidity in fixed income markets. It was a lot thrown at us at once, so I'm going to walk through each one and how it might help. I'll skip over some very technical details, but feel free to reach out with questions. Fed Swoops in In terms of the Fed's traditional quantitative easing program, this was explicitly expanded to being unlimited: unlimited QE for Treasuries and agency mortgage-backed securities, and added agency commercial mortgage-backed securities. Specifically, the Fed said purchases would be in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions. So, unlimited. For at least this week, the New York Fed said it would be buying $75 billion of Treasuries and $50 billion of mortgage-backed securities. For context, the original QE program was $600 billion of mortgage-backed securities in total, which at this pace the Fed would exhaust in 12 trading days. During QE3, they bought $40 billion of securities per month. Now they are buying 3-times that per day. In a small, but notable change, the Fed added agency-backed commercial mortgages to their buy list. Fannie Mae and Freddie Mac are an increasingly large part of the low- and middle-income multi-family mortgage market, so this would keep that market functioning. This move is already improving liquidity within Treasury bonds. Bid and ask spreads have come in to closer to normal, and the yield gap between on-the-run and off-the-run bonds has been mostly eliminated. Dealers came into this week worried about warehousing the two, five and seven-year Treasury auctions coming through, but that worry seems to be gone. Support for Corporate Bonds and Loans To support more orderly trading of corporate bonds, the Fed set up the Secondary Market Corporate Credit Facility (SMCCF). This facility will purchase outright investment-grade corporate bonds and corporate exchange-traded funds, using an equity investment from the Treasury as a backstop. At today's spreads and given the kinds of companies they will be buying, losses aren't a concern. The inclusion of ETFs is interesting here, and suggests that the Fed's intelligence indicates that ETF outflows are a big part of the problem. The Primary Market Corporate Credit Facility (PMCCF) will make direct loans to investment-grade companies for up to four years. The interest rate will be informed by market conditions. That may mean as a practical matter that the Fed will buy a portion of these loans alongside other investors. If not, it isn't clear how the rate will be set. Regardless, I think this program is designed to ensure companies can access markets to roll over debt should markets become truly frozen. These two programs get directly at two major question marks that are leading to severe illiquidity. First, dealers just don't have enough capacity to keep taking bonds into their balance sheet, and hence can't perform a normal market making function. The SMCCF (along with the classic QE) will alleviate that capacity problem directly, by literally pulling those bonds off dealer balance sheets. The second issue is worries that merely because of market malfunction, an otherwise solid company might be forced into bankruptcy or fire selling assets. The PMCCF should mitigate that risk. Corporate bonds are reacting very favorably to this news. Many high quality credits are 20 basis points to 40bps tighter on the day. This, despite the fact that stocks are down sharply and high-yield bonds are 1-2 points weaker. In other words, the securities where spread widening has been mainly about illiquidity are rallying. The market segments that are mainly about true economic risk are not. Adding Asset-Backed Securities The last of the major programs was the revival of the Term Asset Lending Facility, or TALF. This was a crisis era program aimed at unlocking the asset-backed security market. In it, the Fed will provide non-recourse funding to buy recently issued AAA-rated asset-backed security of certain types (mainly consumer asset-backed security and SBA loans). Because the loans are non-recourse, the borrower is only risking the amount of the haircut the Fed applies. And because it is term financing, the borrower doesn't need to worry that funding will get pulled away from them. In 2008 to 2009, this program was successful so far as it went, but because that recession centered around consumer lending, the TALF alone couldn't heal the consumer asset-backed security market. Conditions in 2020 are much more favorable for this program having a bigger impact. If the Fed can keep the asset-backed security market healthy, that it will allow non-bank lenders to keep supplying credit to consumers, and allow bank lenders to free up balance sheet space for various purposes. But the program size could be a headwind. The total size of lending under TALF and the two corporate bond programs are only $300 billion for the moment. That is because the Fed cannot make loans of these types without an equity backing from the Treasury. The Treasury only has discretionary funds of $30 billion, which the Fed is effectively leveraging to $300 billion. But Treasury Secretary Steven Mnuchin intends on having a large amount, supposedly $400 billion, authorized under the Covid-19 stimulus packing negotiated in Congress. That would turn these programs from $300 billion to $4 trillion. Municipals: A Glaring Omission Many commentators, including Minneapolis Fed President Neel Kashkari, have suggested that the Fed should be intervening in the municipal bond market to help alleviate liquidity problems there. But no such support came in Monday's announcement. Exactly why the Fed didn't include any muni-bond buying is unknown. But people I've talked to suggested that the Fed expects fiscal support to come to municipals, and either the Fed can include munis when their buying power increases, or else they ultimately won't need to buy munis once the fiscal support is enacted. The Fed is including municipal money market securities in their Money Market Liquidity Facility, but this has been a small part of the muni market challenges to date. So unfortunately, the muni market gets to wait and see. Enough to Unlock the Bond Market? It is always hard to know exactly what is going to be the right policy mix. However this is a wide ranging set of programs that touches most of the largest parts of the high quality bond market. In other words, with munis as an exception, it should make a meaningful difference in all the bonds where true credit risk isn't an acute problem. As of Monday afternoon, it is having the desired effect.

Now, It's Fed Unlimited

The quantitative easing program was explicitly expanded to become unlimited, so let's pick through the details of what this means -- and what it means for bonds.

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