What ammunition did the Fed deploy and why?
As outlined in our piece from two weeks ago, the previous 50 bps cut was merely a harbinger of additional easing to come due to escalating disruption wrought by the coronavirus outbreak. After a brief reprieve following the last cut financial conditions resumed tightening at an accelerated pace, culminating in investment grade and high yield credit spreads widening by 65 and 177 bps, respectively last week, and the S&P 500 falling by over 8%.
Accordingly, the Fed was compelled to unleash a comprehensive package (lining up with the intuition that it pays to “go big and go early” near the zero lower bound), underlying its resolve to fire heavy artillery at a formidable and unpredictable threat. While the Fed adopted an array of measures, we highlight the three principal adjustments below:
- Cut the policy rate by 100 bps to a range between 0 - 0.25% to provide broad based support to the economy
- Pledged to buy at least $700 billion ($500 billion in treasuries, $200 billion in agency MBS) worth of securities to improve liquidity in affected markets. The Fed chose to “support the smooth functioning of markets for treasury securities and agency mortgage-backed securities” after observing:
- Spikes in real yields and mortgage rates
- Deterioration in treasury market liquidity, characterized by atypically wide bid-ask spreads
- Cut the discount rate by 150 bps to 0.25% to provide support to credit markets -- The Fed hopes to destigmatize the use of the discount window and incentivize increased use by depository institutions to meet emergency funding needs
Another round of easing brings another round of questions for market participants. Two immediately jump to mind:
- Is the Fed now out of bullets?
- Will the Fed’s package prove to be a panacea for the virus?
On question one, we agree with Chairman Powell that although the Fed seemingly threw “the kitchen sink” at the virus, additional monetary policy space remains. Further tweaks to quantitative easing (larger monthly pace, making QE open-ended, and exploring different security types to buy) stand out as viable options for further easing. Other alternatives include solidifying the much talked about shift towards average inflation targeting and yield curve control (a la the BOJ). However, we believe the much speculated negative rate policy question lies firmly outside of the Fed’s current playbook, and Chairman Powell corroborated as much when asked about the prospect during the Q&A session.
With respect to question two, we view the announced measures as another big step in the right direction. Market functioning had clearly deteriorated and the Fed acted decisively to address the aforementioned issues. Orchestrating the largest one day rate cut in years, in addition to an even larger cut in the discount rate, should eventually provide significant support to credit markets, although the initial market reaction was underwhelming.
The Fed’s actions were largely aimed at lubricating financial markets that appeared to be seizing up, with the hopes that an enhanced monetary policy transmission mechanism would end up flowing through to businesses and households. However, the increasingly entrenched orthodoxy of “social distancing” has engineered a sudden stop in the U.S (and global) economy, and will likely trigger a contraction in Q2 due to the unprecedented disruption to economic activity. Consequently, market participants have demanded even more stimulus to improve risk sentiment.
We believe that this is the juncture for governments around the world to step up and fill the vacuum with targeted fiscal policy. There have been tentative steps in this direction, but as entire industries are shutting down to “flatten the curve” of infections, investors are waiting for those steps to transform into a full-fledged sprint.
As we stated in our previous piece, we believed the U.S. economy was on solid footing prior to the outbreak. It is difficult to forecast how long the disruption will last, but we feel confident that when the threat subsides at some point in the second half of the year, the U.S. economy will be bolstered by joint tailwinds of pent up demand and highly accommodative monetary policy, as the Fed’s policy rate will remain at zero at least until growth and inflation expectations returns to the Fed’s target. Until then, we expect bouts of elevated volatility in the short term and are proceeding cautiously.