Global Head of Fixed Income Jim Cielinski and Head of US Fixed Income Greg Wilensky outline key aspects of the policy actions recently announced by the US Federal Reserve (Fed) in response to the COVID-19 pandemic and explain why the central bank has established itself as the lender of last resort.
- The scope of the Fed’s recently unveiled lending programmes makes it clear that the central bank has entered new territory in its commitment to addressing the economic impacts of the COVID 19 pandemic and restoring normal functioning to markets.
- The announcement on 9 April was a powerful mix of new programmes and additional details on previously announced programmes designed to help alleviate short-term solvency concerns.
- However, while these actions are a game changer for the Fed, a brutal recession still awaits, and many companies and other borrowers will inevitably emerge from the crisis in weaker shape.
The package of measures introduced by the Federal Reserve to address the COVID-19 crisis is unprecedented and effectively puts them on a new policy course. For those still harbouring doubts regarding the Fed’s willingness to break new ground in facilitating borrowings, those doubts were eviscerated last week as the Fed rolled out the details of previously announced programmes and unveiled new programmes. By embracing a policy of both indirect and direct lending across a range of corporate, securitised and governmental borrowers, the Fed has truly upped its game as the lender of last resort. Similarly, these moves eliminated any lingering concerns about the willingness of a Powell led Federal Reserve to improvise away from the central bank’s Global Financial Crisis (GFC) response script.
For most of its existence, the Fed has relied on lowering interest rates to restore economic growth. Lower rates and an increasing money supply would lead to lower borrowing costs, providing the tonic to foster credit creation and get the economy back on its feet. When they bumped into the psychologically important zero level for policy rates during the GFC, the Fed expanded their toolkit with quantitative easing (QE) to further reduce borrowing costs, as well as programmes to support banks, brokers and other market makers’ ability to facilitate market transactions. They also created lending programmes such as the Term Asset-Backed Securities Loan Facility (TALF), which targeted the epicentre of the crisis.
With the additional steps introduced last week on top of the previously announced policy moves over the past month, however, the Fed has made it clear that they have migrated to an entirely new place. There is no going back. Welcome to the new Fed.
US Federal Reserve balance sheet
Source: Bloomberg, 28 June 2019 to 8 April 2020.
As with all policy regime shifts, we must focus on two fronts when assessing these new developments. First, we must understand the details of the package to understand how they work and how they will impact economies and markets. Second, in any shift of this nature, we need to step back and evaluate the broader message, as it is likely to have a profound impact on how we invest and is likely to permanently alter the market’s assessment of the ever-important policy response function.
Last week’s announcement was a powerful mix of truly new programmes (ie, the Municipal Liquidity Facility), the first official details on programmes that have been highlighted as “coming soon” (ie, the Paycheck Protection Lending Facility, the Main Street New Loan Facility and the accompanying Main Street Expanded Loan Facility) and additional details on and changes to previously announced programmes (ie, Primary Market Corporate Credit Facility (PMCCF), the Secondary Market Corporate Credit Facility (SMCCF) and the above-referenced TALF).
The Fed’s policy announcements earlier in March looked somewhat like a video of the Fed’s GFC response played at 4x speed: lower rates to the zero bound, start buying Treasuries and mortgage backed securities, and offer financing support (as the lender of last resort) to market intermediaries to ensure markets can function and that excess liquidity premiums resulting in rapidly falling risk asset prices could be reduced.
Via those announcements, the Fed clearly stated they would do whatever it took to bring markets back from the brink and ensure they function more normally. These initial steps appeared to be very effective: financial markets did in fact begin to operate more smoothly, prime money market funds and the securities they invest in began to normalise, the new issue investment grade corporate bond market came back with record issuance across a broad range of issuers, and even the new issue market for bonds and loans for below investment grade issuers started up again. At the same time, spreads on all types of credit-sensitive fixed income bonds tightened materially from the wide levels seen in the first half of March and equities recaptured a material portion of their declines.
Recent US corporate bond spreads and equity prices
Source: Bloomberg, 28 June 2019 to 10 April 2020. Spread is the Option-Adjusted Spread (OAS), which measures the spread between a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
Admittedly, some of the rally in credit spreads was a function of the Fed’s initial indication that they would go further than they had during the GFC to provide support to large investment grade issuers as well as small and medium-sized companies. However, the true size of these programmes and the Fed’s willingness to go beyond simply putting a cap on the level of spreads was unclear. It was also unclear that the Fed would go beyond taking on credit risk for the investment grade issuers and AAA securitised assets that would almost certainly be able to survive the coming economic downturn as long as the liquidity-driven sell-off frenzy was short-circuited.
The announcements on 9 April provide answers to these questions – and then some. While it is still not clear how much buying/lending the Fed will do in some of these programmes (there are several “the Fed MAY buy up to” statements in the announcement), it is clear that the Fed has moved beyond simply trying to place a cap on the level of credit spreads. Rather, they seem intent on driving credit spreads even tighter than the levels they had recovered to. While credit spreads are still significantly wider than at the beginning of the year, the overall yield levels at which many investment grade issuers are issuing new bonds look attractive versus historical levels. Of course, for investors, the question is whether this combination of spreads and yields offer enough compensation for what is likely to be at least a short but very severe recession with tremendous uncertainty regarding the path to recovery.
The latest details
So, what did the Fed do on 9 April? The details are numerous, but the following is a summary of the key aspects – most of which were broader than expected – and their potential impacts.
- The Fed will include ‘fallen angels’ (high yield issuers that were recently investment grade) in their primary and secondary corporate bond purchase programmes. Potential impact: softens the blow for deteriorating credits that had seen their cost of financing soar in recent weeks and mitigates the penalty for falling from a BBB rating to high yield for other issuers.
- The inclusion of high yield bonds in the Fed’s purchase programmes will take the form of exchange traded fund (ETF) purchases, allowing the Fed to support a broader market rather than choose individual companies. Potential impact: the size of intervention is unknown but sends an important message that demonstrates the Fed’s support for companies that are closest to default.
- The Term Asset Backed Securities Loan Facility (TALF) eligibility rules were expanded to include some previously issued commercial mortgage backed securities (CMBS) and newly issued static collateralised loan obligations (CLOs). Potential impact: while the expanded rules are supportive at the margin, the restrictions are still material and will not provide a panacea for facilitating new loan origination.
- The details of the two Main Street Loan Facilities and the Paycheck Protection Program Lending Facility were rolled out. Potential impact: in addition to helping small and medium sized companies navigate this crisis via increased access to affordable financing (and forgivable loans in some cases), these facilities will limit the impact of defaults to banks and free up the balance sheets of banks and broker-dealers. With lower defaults and more balance sheet capacity, banks are better positioned to extend credit to other borrowers and to facilitate the economic recovery.
- The Municipal Liquidity Facility will facilitate direct issuance of debt by certain states and municipalities. Potential impact: in conjunction with fiscal programmes that will likely be announced in the future, this programme will substantially soften the blow from the crisis on state and local governments.
The Fed’s actions will make it easy for companies to access the capital markets to build liquidity buffers that can help them endure the severe economic contraction resulting from global efforts to contain the COVID 19 health crisis, as well as refinance their maturing debt over the next few years. In addition to improving the market technicals by adding a significant amount of demand for credit-related debt, the Fed’s actions also help bolster the near-term fundamental outlook for these issuers by essentially eliminating short-term solvency concerns.
Questions remain as recession looms
While their recent actions are a game changer for the Fed, companies and other borrowers will still emerge from the crisis in weaker shape. Debt loads, already high, will still increase in the coming months and years. Access to capital, although critical for deserving borrowers, is not a cure for weak companies; rather, it is a path through difficult times. With recessions, however, come earnings collapses. The Fed’s actions have helped remove an important tail risk, but a brutal recession still awaits.
Furthermore, many open questions remain, including the pricing of some of the facilities, the seniority of the Fed’s position as a creditor, the size of the Federal Reserve’s actual purchases and the prices at which they will conduct purchases in the secondary market. The answers to these questions are all material to the market response.
Some of the facilities will likely not get much use. The Primary Market Corporate Purchase programme, for example, carries origination fees of 100 basis points (bps), in addition to other constraints, limiting its use by most high quality public companies. As with so many details of this package, however, we must also factor in the ability of policymakers to intervene and quickly change the rules of the game if the programmes are not functioning as envisioned. For example, the Fed still has plenty of dry powder to expand upon its unprecedented entrance into financial markets. The US$195 billion of programmes announced last week pales in comparison to the US$454 billion that was appropriated by Congress to the Fed as part of the CARES Act. Through the use of leverage, the Fed has nearly US$3 trillion more it could deploy toward the expansion of existing programmes or new programmes targeted at yet-to-be-seen cracks in financial markets.
Where do we go from here?
The full policy package will ensure that we do not face classic liquidity issues that allow markets to freeze up and produce a self-reinforcing deleveraging dynamic. The message, however, is that policymakers will respond by doing what they can to protect the economy. For those imperiled borrowers that have yet to see programmes targeted specifically toward them, those programmes will likely be forthcoming if stresses worsen. And most of the existing programmes will be easy to change or upsize now that they are in place. Markets are forward looking, and they can expect a proactive policy response.
Importantly, monetary and fiscal policies operate with a lag: policymakers will keep the taps on until they see improvement but that may take several months. It will be exceedingly difficult to know when they have done enough but we can expect them to err on the side of easiness – even if the pandemic eases. This sentiment will allow the markets to price out a worst-case outcome and look ‘over the valley’, as long as the duration of the slowdown remains short.
The specific steps are important for determining the behaviour of markets. As with most policy pronouncements, the initial reaction will be to simply ‘buy what the Fed buys.’ There is some truth to this, but we must bear in mind two things: first, it is the full package of what they have delivered, rather than each individual programme, that will drive markets, and second, for policymakers, the ‘message’ can often be as important as the actions themselves.
We have been getting more constructive on risky assets such as corporate bonds and securitised assets. This was predicated on extreme valuations, policymaker panic and signs that the COVID 19 curves were flattening. Last week’s announcements underscore the degree to which policymakers will go and thus it will provide a relief to markets. It is highly unusual to face such a wall of policy actions so early in a recession but this is no ordinary recession. The bad news will be coming fast and thick in the coming weeks, but policymakers are screaming, “Nothing to see here, come back in a few months and all will be well.” Time will tell if this is good advice, but we believe it warrants a more constructive outlook.