To Infinity (and Beyond)

The Fed announced Quantitative Easing (QE) will now be open-ended and expanded the range of securities it will buy.  With these new measures, the Powell Fed will boldly go where no Fed has gone before.  Below are our reflections on the measures and what lies ahead.

RECENT DEVELOPMENTS

The Fed just announced that it would continue QE indefinitely.  Specifically, the Fed said that it will buy “in the amounts needed to support the smooth functioning of markets for Treasury securities and agency MBS.”  No ifs, ands, or buts.  Just a week ago, the Fed restarted full-on QE and planned on buying “at least” $500 bln of US Treasuries and $200 bln of agency MBS.  While that statement was somewhat open-ended, the latest announcement should remove all doubts that the Fed is willing to flood the market with dollars.

The Fed will buy investment grade corporate bonds for the first time ever through two new programs.  We are starting to see some stabilization in the high-grade corporate sectors as a result, although the high yield sector remains under pressure.  The Secondary Market Corporate Credit Facility (SMCCF) is meant to provide liquidity in the secondary market for outstanding corporate bonds.  Many markets have not been functioning well and so the Fed is right to step in here as the buyer of last resort in the secondary market. The Primary Market Corporate Credit Facility (PMCCF) will support new bond and loan issuance.  We think this is much more controversial, as the Fed is in effect lending directly to corporates.  Clearly, the Fed feels that there is some sort of disintermediation going on that requires it to take up the role of direct lender.

Other programs were announced.  The Fed said that its Term Asset-Backed Securities Loan Facility will support student loans, auto loans, credit card loans, and other types of loans.  The Fed will also expand its existing Money Market Mutual Fund Liquidity Facility to include more securities, including municipal variable-rate demand notes.  The Fed said it would also expand its existing Commercial Paper Funding Facility to include high-quality municipal debt.  Both of these moves would help support state and local issuers.  Lastly, the Fed said it “expects to announce soon the establishment of a Main Street Business Lending Program to support lending to eligible small and medium-sized businesses, complementing efforts” by the Small Business Administration.

 

WHAT ELSE CAN THE FED DO?

Despite the aggressive measures taken by the Fed so far, it still has other tools at its disposal.  Countless targeted loan programs are possible for various sectors of the US economy.  Here, we look at three macro moves that the Fed could make if the crisis were to worsen again.

  1. The Fed could widen the scope of its bond purchases. This was done during the financial crisis and is being done now. It’s possible that purchases could eventually include sub-investment grade bonds, though we suspect this will be a much tougher call.  Relief for the energy-focused sub-investment grade companies may be better addressed on the fiscal side – if at all.  That said, it is clear that the boundaries between the two realms are blurring.
  2. The Fed could start purchasing equities. It sounds controversial but with the Fed now lending directly to corporates, this may not be so difficult to do. The Bank of Japan has been buying equity ETFs since December 2010.  It was meant to be a temporary program that ended in 2011 with a cap of JPY450 bln for ETFs tracking either the TOPIX or the Nikkei 225.  The  program remains in place nearly ten years later, and the bank doubled the ceiling for ETF purchases recently to JPY12 trln ($112 bln).  It holds over 75% of the ETF market in Japan, making the BOJ the top shareholder of more than 55 companies in the Nikkei 225 index.  The problem here is that ETFs do not mature and would remain on the Fed’s balance sheet until it sells them.  The BOJ recently acknowledged unrealized losses of JPY2-3 trln ($18-27 bln) on its ETF holdings.  The Hong Kong Monetary Authority bought 11% of the Hang Seng Index during the Asian crisis using its foreign reserves.
  3. The Fed could intervene in the FX market. With the world clamoring for dollars, why shouldn’t the Fed give them more? Well, the Fed already is flooding markets with dollars via QE and the global swap lines.  That is the preferred method since it has no direct impact on exchange rates.  We think intervention would be much more difficult and contentious, but if it happened it would probably involve weakening of the dollar, which (at least G7 countries) may not see as a favorable outcome. .  We do not think there is broad-based concern on the part of European or Japanese officials regarding a major “misalignment” of exchange rates.  This is a very different environment than what was seen during the 1985 Plaza Accord.  As the chart shows, the rise in the dollar then dwarfs the dollar rally over the past year or so.

 

INVESTMENT OUTLOOK

The dollar typically does poorly at the onset of each round of QE before recovering.  Granted, the sample size is small but it’s all we’ve got.  Fed first started Quantitative Easing (QE) in November 2008 when it announced plans to purchase $600 bln of agency mortgage-backed securities (MBS).  DXY fell around 12% over the next month but then recovered to trade even higher by March 2009.  QE1 was extended in March 2009 with another round of agency MBS purchases worth $750 bln as well as $300 bln worth of longer-dated US Treasuries.  DXY fell around 17% over the next eight months but then recovered nearly all of its losses by June 2010.

We maintain our strong dollar call whilst wholeheartedly admitting that the Fed has made it harder to maintain.  We are already seeing some knee-jerk selling of the dollar, but we believe it will eventually recover.  Why?  Virtually every major central bank is engaging in near unlimited QE with zero rates.  As such, every currency is now more or less on a level playing field.  Much of the dollar outlook will depend on how well US policymaker work to contain the virus.  Despite the dire near-term US outlook, we maintain our view that the US economy remains best-positioned to deal with the effects of the coronavirus and that the dollar should ultimately benefit from this.

US Treasury markets are reacting to the extra measures as one would expect with yields down across the board.  But spread product has not tightened up as much.  This is understandable given the huge uncertainty about default rates in the near term and the problems in the energy sector, where defaults are almost certain to happen, but the magnitude is unclear.

The ongoing expansion of the Fed’s balance sheet should help ease dislocations in the funding markets.  The Fed was already expanding its balance sheet to boost excess reserves in order to prevent a return of the repo market chaos of last fall.  The full-tilt QE now under way should head off further dislocations resulting from too few excess reserves in the system.

When all is said and done, the Fed is clearly doing all it can to treat the symptoms being seen in the financial markets.  The Fed will now back-stop even more types of debt in an effort to get these markets back to being somewhat functional.  Still, we view the Fed’s measures as time-buying exercises that will keep the economy afloat until the virus numbers improve.  Until that happens, policymakers are basically doing what they can to prevent the virus from killing real economy.  Life support.

Lastly, one must note that the speed of all these actions is nothing short of breath-taking. The first emergency 50 bp rate cut was made March 3.  Less than two weeks later, rates were cut another 100 bp and QE restarted on March 15.  Barely over a week later, the Fed made QE open-ended today.  During the financial crisis, the Fed’s policy moves (rate cuts, QE, loan programs, etc.) were taken over the course of months and years.  This time, the Fed has a playbook in place and has shown a willingness and ability to act quickly and aggressively.

We remain skeptical that the aggressive moves by the major central banks and governments can do much to offset the still-growing impact of the coronavirus.  Until the scope of the virus outbreak is better known, we see no reason to get optimistic on global growth prospects.  As such, we remain cautious on equities, EM, and commodities despite their recent bounce.  The dollar should eventually recover to make new highs, though we see scope for further near-term weakness as markets digest the Fed’s aggressive approach to QE.