The Federal Reserve’s Red Line

In an interview on May 29, 2020, hosted by Princeton University’s Griswold Center for Economic Policy Studies, Chairman Jay Powell put forward perhaps his boldest statement yet amidst one of the largest Fed endeavors in its history:

“We crossed a lot of red lines that had not been crossed before…I’m very confident that this is the situation where you do that and then you figure it out.”

Let’s look at some additional comments from Powell on May 29, 2020:

  • Days away from the first “Main Street” lending loans.
  • Forward guidance and QE are no longer non-standard tools.
  • “No” to negative rates.
  • Roughly 40% of people making $40,000 or less have been laid off.
  • Little risk with what we’re doing right now to inflation or financial stability
  • Comfortable now, but balance sheet can’t go to infinity.

Powell as Fed Governor and now Chairman

Over the course of time, there has been considerable criticism of the Federal Reserve. More recently, criticism has been especially intense as many blame the Fed for the growing inequality in the U.S., whereas there are those privileged and exposed to risk assets over time enjoying the so-called “Fed put,” while others are lacking opportunities in lower income communities.

Then of course, there’s the declining element of the middle class which continues to get monetized over time. The so-called “Fed put” began way before this current Federal Reserve. Alan Greenspan was the first to be keenly focused on the stock market and ultimately holding rates “low for too long” and likely leading to the housing bubble of 2008.

In Powell’s July 29, 2019, semi-annual report to congress he stated:“The relative stagnation of middle and lower incomes and low levels of upward mobility for lower-income families are also ongoing concerns. In addition, finding ways to boost productivity growth, which leads to rising wages and living standards over the longer term, should remain a high national priority. And I remain concerned about the longer-term effects of high and rising federal debt, which can restrain private investment and, in turn, reduce productivity and overall economic growth. The longer-run vitality of the U.S. economy would benefit from efforts to address these issues.”

We have been in the camp that Powell is one of the more thoughtful Fed Chairs in recent time; this is not to say we haven’t been critical since 2018. His statement from May 29 certainly garnered attention. In many ways, however, although the Fed has crossed red lines, our hope is that much of what’s put in place will not be needed. And certainly, when looking at the corporate bond market, much has been achieved in terms of liquidity with very little Fed balance sheet deployed.

In Powell’s words, “When the crisis is behind us, we will put these programs away.” This seems very unlikely, but time will be the judge.

Considering the extreme severity of the global shutdown, coronavirus and now unrest in the U.S., one wonders how things would look had the Fed not acted since the beginning of March. Sure, things in many cases feel better now, in hindsight. Mind you, we believe it is still early days in this crisis unfortunately, but the likely economic reality in the coming months and performance of risk assets remain mutually exclusive. This is certainly not a new phenomenon.

March 2020 was a very dark month, perhaps more so than most understand. Recently the Fed, and Powell in particular, have spoken about liquidity issues becoming solvency issues over time. In the end, there are limitations to the Fed’s actions. Buying Treasuries and mortgages does not solve cashflow issues on the part of households and small businesses. Nor does it keep people afloat when the economy is shut down. It is certainly not a vaccine to thwart a global pandemic or convince businesses to rehire when the demand is not there. While it’s true that financial conditions are better, it’s not the medicine to get this economy truly running again. This will be a structural and permanent change to our global economic landscape.

Yet, the purchasing and insertion into the U.S. Treasury market was critical as the world’s most liquid sovereign market and US risk-free rate was completely broken. All bets are off with other asset classes if the presumably most liquid pricing and hedging benchmark is not functioning. The market was seeing 20 to 40 basis point swings in 10-year yields a day, prices in long bonds did not exist at certain times and off the run securities were not trading. Arguments could certainly be made that many of the Fed’s actions since the crisis of 2008 contributed to the problem they needed to solve. Nonetheless, the Fed needed to quell the volatility, and they did.

BOA ICE Move Treasury Volatility Index, January 2020 – June 2020

In many ways, this crisis around the coronavirus and global shutdown is a fiscal challenge. If the government requires an economy to shut down to protect its people, finding a way to keep things afloat quickly and prudently is incumbent. Yet, had we not solved the liquidity issues first with the Federal Reserve’s initial actions, our global economy would be in far worse shape right now; however, it’s still extremely bad. Coupled with this, the fiscal response has been slow, politically contentious and ridden with the need for continued change as can be seen from the Paycheck Protection Program. Our track record on the fiscal side has been very poor for well over a decade. Its been poor globally. Not a question our fiscal leaders have continued to lean on excessive central bank liquidity despite their own rhetoric.

In Powell’s days as a Fed Governor, he was always aware of the downside risks to excessive Fed and monetary policies. In the end, the Chairman has a long history outside of government and is keenly aware the role private capital plays.

From a speech on June 27, 2013, Thoughts on Unconventional Monetary Policy, then Fed Governor Jerome H. Powell at the Bipartisan Policy Center, Washington, D.C., spoke on the costs of large-scale asset purchases:

“What of the potential costs or risks of the asset purchases? A variety of concerns have been raised over time. With inflation in check, the most important potential risk, in my view, is that of financial instability. One concern is that our policies might drive excessive risk-taking or create bubbles in financial assets or housing…there have been signs of a ‘reach for yield’ in the fixed-income markets for some time. Demand for higher-yielding fixed-income securities has outstripped new supply. The result has been very low rates, declining spreads, increasing leverage, and pressure on non-price terms such as covenants.”

The Federal Reserve Balance Sheet, Effective Funds Rate and the S&P, 2008 – 2018

The Federal Reserve’s attempt to normalize

The Fed began its anticipated liftoff in 2015 after years of zero Interest Rate Policy (ZIRP), increasing balance sheet, sovereign and corporate debt along with little growth. Shortly after liftoff, with the Chinese economy and stock market hitting a major roadblock, The Fed paused their efforts to normalize with a very slow approach through the 2016 U.S. election.

Following the election, stabilization in China, with signs of hope finally on the fiscal side, the Federal Reserve hit the gas raising the Fed funds rate by close to 200-basis points into 2018. All looked good, as equity prices were climbing with the normalization of both real yields and the Fed’s benchmark. It felt like a dream; finally, the fiscal side taking over.

Chairman Powell took over the Fed in 2018, joined by Vice Chairman Clarida in the fall of 2018. At that time, the tariff situation with China was percolating, although still more of an issue in the backdrop with the Fed feeling very convicted the economy was on the right path, the U.S. consumer was strong and the neutral Fed Funds rate closer to 3%. On the surface, there was little reason to believe this wasn’t the case.

Effective Funds Rate, 5-year Forward, 5-year Inflation breakeven and S&P (2016 – 2018)

Underneath the surface: The Fed’s hot button

The Fed talks extensively about financial conditions. Within that context: Looking at long and short rates, equity values, the USD and credit. In the end, as was the case in late 2018 and most recently now into the current crisis, it’s the corporate credit market which seems to motivate the Fed most. Looking back to the market meltdown in late 2018, equity valuations declined substantially, yet many parts of the corporate bond market were not functioning. And when looking back to the beginning of the March 2020 period, Dallas Fed President Kaplan indicated clearly what he was watching: 

In a Fox Business interview in late February 2020, Kaplan stated:

“[I am] watching the impact of the coronavirus and credit spreads, liquidity and the availability of capital.”

As the Fed made their final hike in 2018, markets cratered to the point that Chairman Powell needed to intervene at the beginning of January with the pivot, followed by the mid-cycle adjustment and then ultimately the balance sheet expansion in late 2019 to resolve the repo hiccup which took equities to their highs and credit spreads and volatility to new lows heading into 2020; then came the coronavirus.

Since the global financial crisis, we have accumulated trillions in outstanding debt fueled in large part by a low to negative interest rate environment globally. Certainly, as the crisis began to subside, there was both a combination in the availability of credit and extremely accommodative rate levels which were utilized both domestically and abroad. Below is a summary from the Bank of International Settlements of total debt securities in the U.S. as of March 1, 2020. The issuance numbers in all buckets from March through June of 2020 are clearly now higher.

Below are four charts which highlight the issues the Federal Reserve had in 2018, in a continued move toward higher funding rates. Today’s window of time, given the extreme funding needs from Coronavirus, extreme low rate levels, the Fed’s willingness to expand their balance sheet and liquidity programs, will lead to higher debt levels along with more growth challenges in the coming years. Certainly, there are risks of a vicious cycle back to extreme valuations, potential financial instability, defaults, downgrades and insolvencies down the road. In Powell’s most recent statements, the Fed’s baseline cases will be losses on some of their loans; it may be many.  

BIS Outstanding U.S. Debt as of March 1, 2020

St. Louis Federal Reserve Nonfinancial Debt Outstanding as of March 2020

Total Outstanding U.S. Marketable Sovereign Debt (2010 – 2020)

In reverting back to our prior references to increased volatility in the credit markets, the below chart highlights 5-Year CDS volatility, the effective funds rate, modified corporate duration with reference to extreme spikes in credit volatility, spreads and illiquidity. Specifically, the 2015-2016 pause, the 2018—2019 pivot/mid-cycle adjustment and today’s coronavirus crisis taking the Fed funds rate to zero along with the implementation of multiple credit lending and buying programs. Credit volatility spikes (white), duration (yellow) and effective funds rate (green).

The Fed’s Balance Sheet, lending programs and the upcoming meeting

Since the beginning of March, the Fed’s balance sheet has grown to roughly $7 trillion as of May 28, 2020. On the asset side, the bulk of the growth coming from security purchases in treasuries and agency mortgages ($2 trillion), along with strong demand for the international swap liquidity lines which are higher by $450 billion.

Regarding Fed liabilities which is most important, there have been large increases to Bank Reserves, the Treasury’s General Account to fund the fiscal liquidity initiatives for coronavirus and currency in circulation. The largest increase by far have been the Bank Reserves. Bank Reserves ($3 trillion), currency in circulation ($2 trillion) and the Treasury General Account ($1.3 Trillion).

The Federal Reserve Balance Sheet, Treasury General Account and Bank Reserves

Lending programs: The Fed’s alphabet soup

When Chairman Powell spoke about crossing red lines, he was speaking mainly about some of the Fed’s lending programs. In conjunction with the Department of Treasury and Section 13(3) of the Federal Reserve Act, the Federal Reserve can be a lender of last resort in “unusual and exigent” circumstances. The establishment of Special Purpose Vehicles and the lending to non-financial institutions is where the lines get blurry.

In total the Fed has established nine lending programs; some of which are from the 2008 playbook, and others new. Initially in March, and before the passage of the CARES Act, a few facilities were established and seeded with credit and equity protection from the Exchange Stabilization Fund from Treasury and expanded with additional funds once the CA passed.

Let’s take a look at the updated numbers

Commercial Paper Funding Facility (CPFF): Up and running; established in March with $10 billion in credit protection and is not funded by the CARES Act. Current balance sheet: $13 billion, which includes the Treasury’s investment of $10 billion.

Money Market Liquidity Facility (MMLF): Up and running; established in March with $10 billion in credit protection and is not funded by the CARES Act. Current Balance Sheet: $33 billion which includes Treasury backstop to date of $1.5 billion.  

Primary Dealer Credit Facility (PDCF): Up and running; established in March. Discount Rate plus 25-basis points. Current balance sheet: $6 billion.

Term Asset Backed Securities Loan Facility (TALF): Projected end of June. Funded by the CARES Act with $10 billion in equity for $100 billion in loans.

Two Corporate Credit Facilities (CCF); Primary and Secondary Corporate Facility (PMCCF/SMCCF): Up and running; funded by the CARES Act with $75 billion in credit protection for up to $750 billion in lending and buying capacity. Current balance sheet: $35 billion. Factoring in the Treasury’s contribution, purchases to date are minimal including mainly ETFs.

Main Street Lending Facilities (MSPLF/MSELF/MSNLF): Expected to make loans beginning this month; three different loan programs. $75 billion in equity to fund up to $600 billion in loans to small and medium size businesses.

Paycheck Protection Program Lending Facility (PPPLF): Up and running; $350 billion against the setup through the CARES Act. Current balance sheet $50 billion.

Municipal Lending Facility (MLF): Notice of interest and documentation available. The state of Illinois has agreed to a loan from the Fed for a little over $1 billion. This is funded through the CARES Act with $35 billion in equity for $500 billion in short dated loans. The Treasury’s credit injection to date is $17.5 billion.

In total to date, the Treasury has “slated” roughly $215 billion in equity and credit protection for the Fed’s lending programs since March with $66 billion physically moved to the Fed’s balance sheet. The leverage factor varies by program and asset credit rating. In terms of the CARES Act, the Treasury has announced just under half ($200 billion) of the $454 billion of allocated funds toward the existing programs. This leaves room for additional support toward the existing programs or expansion for new ones in addition to the $2.3 trillion in leverage designated above.

The upcoming Fed meeting

The Fed will conduct its next meeting on June 10 with the economy reopening, but under continued stress. Certainly, the riots and protests around the country have added an element of uncertainty to the economy. Our general belief for the Fed is a continued focus on the implementation of existing lending programs. The two programs in focus right now are the three Main Street Lending Facilities and the MLF.

In a speech on May 21, 2020, Vice Chair Clarida stated, in regard to monetary policy:

“But there is one thing that I am certain about: The Federal Reserve will continue to act forcefully, proactively, and aggressively as we deploy our toolkit—including our balance sheet, forward guidance, and lending facilities—to provide critical support to the economy during this challenging time and to do all we can to make sure that the recovery from this downturn, once it commences, is as robust as possible

In regard to lending facilities, Vice Chair Clarida stated:

“But importantly, these are, after all, emergency facilities, and someday—hopefully soon—the emergency will pass. When that day comes and we are confident the economy is solidly on the road to recovery, we will wind down these lending facilities at such time as we determine the circumstances, we confront are no longer unusual or exigent.”

Within just a short three months, the Fed has moved as quickly and forcefully in ways markets have never seen. As top Fed officials continue to stress the continued need for bold action (including Powell and Clarida), actions to date on many of the lending facilities have been limited but with good results in improving financial conditions. The Fed is very aware of the territory they’ve entered. Powell has told us now. And with that, and the crossing of Red lines, moral hazard become a clear concern just as it was in 2008. Yet this time the stakes are far greater.

On June 3, 2020, Former New York Fed President Bill Dudley told Bloomberg Television:

“People who have a high-yield debt that’s outstanding, a lot of times that’s happened by choice. So for the Federal Reserve to intervene and support those asset prices, is basically creating a little bit of moral hazard in the sense you’re encouraging people to take on more debt.”

Even so, despite the Fed’s aggressive actions, there have been several themes in the marketplace since calling for more in the last Fed meeting. In many ways, like the crisis of 2008, when rates move to zero the natural question is: what’s next?

Below are the tools the Fed has left to discuss:

  • Expanded lending programs: Treasury has more than 50% left through the CARES Act.
  • Balance sheet: Powell recently said this is no longer a non-standard tool.
  • Forward guidance: Defining parameters around employment and inflation to change course; no longer non-standard (Powell).
  • Negative Interest Rate Policy (NIRP): Setting the benchmark rate below zero; Powell and other members have deflected.
  • Yield Curve Control (YCC): Setting the price (rate) level at a certain point or points along the curve and capping rates.

Expanded loan programs

Powell will speak about the Fed’s programs. More specifically, we would expect him to talk about the process of getting the Main Street Lending Facility online, with additional comments around the Municipal Liquidity Facility. He may offer comments on the expansion of the municipal side, which remains a concern; more so now with the rioting across the country and the fiscal response politically divided. Recently, on June 3, the Fed most expanded the MLF to allow states the ability to have at least two cities or counties, regardless of size, the ability to issue directly to the Fed.

Balance sheet

The balance sheet is now at $7 trillion. Asset purchases have slowed, yet the balance sheet will naturally expand as the lending facilities come online. Powell has indicated that quantitative easing is no longer a non-standard tool. So, the Fed will carry a larger balance sheet for a longer period and continue to support the Treasury market and supply dynamic as needed. We don’t view the recent pairing down of weekly purchases as the necessary way forward.

Forward guidance

The economy is still in a state of shock. As such, it is likely too early for the use of strong language around forward guidance. This too is now a non-standard tool and we do expect it at some point. The first order of business would be restoring the summary of economic predictions by the committee which was suspended due to the severity of economic shock. The intended timetable for restoration was for the June meeting, but the numbers are still very distorted and the reopening uneven. Nonetheless, this would precede any type of strong forward guidance and we look out for SEP on June 10.

Then-Fed Governor Powell discussed forward guidance in June 2013:

“The committee will continue to use interest rate policy, including forward guidance about short-term rates, as we return to full employment. Provided inflation remains in check, the committee will begin to assess whether to increase short-term rates when unemployment reaches 6.5%.”

Negative rates

The European Central Bank and the central banks of Denmark, Japan, Sweden and Switzerland, have been experimenting with negative interest rates; essentially making banks pay to park their excess cash at the central bank. We have been adamant and so has Powell, and other Fed members, that this is not in the cards. When you look at all the Fed has done over the past few months: increasing bank reserves dramatically and reducing regulatory burdens to facilitate lending, NIRP would be a direct contradiction. Aside from the fact that there is no practical evidence these policies have worked when looking at the economies with central banks that have used. In the end, there is a difference between cash markets trading negative and a formal policy. Powell may very well be questioned as market pricing has naturally pressed the Fed, but we expect him to push back in line with his intermeeting comments.

Yield curve control

We think this would be the next logical step for the Fed to add onto ZIRP. Although we don’t expect to see it just yet. It is currently being used in Japan and most recently by the RBA in Australia which has set a duration bogie of 3-year and consistent with their projection for short term interest rates. The Fed has discussed YCC at their most recent meeting and in the past. And early indications would be a target of 5-years and under which would be consistent with some recent Fed speak as to how long they expect to be at the ZLB. Yield Curve Control was used in the 1930’s in the US. And it’s not clear how effective it would be, especially if the Fed were to let long end rates drift higher as the economy slowly recovers. We still think the Fed will look to keep long end rates low, even despite an economy that shows signs of recovering. Nonetheless, Powell will likely be questioned about YCC, in addition to other tools the Fed potentially has left.