Former U.S. Treasury Secretary Hank Paulson, in the early phases of the financial crisis, described the Troubled Asset Relief Program (TARP) as a policy “bazooka” that the Treasury Department wanted just in case.
On Sunday, March 15, Federal Reserve Chairman Jay Powell upped the ante by pulling a nuke out of his arsenal.
The Fed, just before the open of New Zealand and global futures market trading on Sunday, announced that the U.S. central bank would:
- cut its target for overnight interest rates by 100 basis points to a range of 0.00%–0.25%;
- embark on a $700-billion plan of quantitative easing (QE) bond buying;
- and take various related actions to prop up global funding markets.
While the Federal Reserve couched their primary decision to cut rates in terms of growth and inflation, the other actions are arguably more significant and—at risk of mixing metaphors—are driven by the need to unclog market plumbing. We will
address the rate cut, the liquidity announcements, and provide a brief outlook for the interest rate markets.
The U.S. economy is either in, or heading towards, a recession. Social decisions related
to the coronavirus are deeply impairing economic activity in the last month of the first quarter of 2020, and will almost certainly last into the second quarter of this year.
Even the most astute economist can only guess the magnitude of the contraction. While the Federal Reserve cannot restore economic activity from contraction, by cutting overnight interest rates back to the zero lower bound, the Fed is attempting to provide a measure of demand-side stimulus by lowering borrowing costs to crisis-era lows. Part of the hope is that the rebound after this (hopefully) brief contraction will be much faster with a Fed at the zero lower bound; in essence, the goal is to create a sort of slingshot growth on the other side of the contraction.
Unclogging market plumbing
On March 13, we published a note discussing various forms of Fixed Income Market Dysfunction. While our note focused on why trading in investment-grade
corporate bonds and municipal bonds was wildly different from trading in Treasury markets, there were also numerous technical problems with market plumbing.
Market plumbing is the term we use for the flow of payments that most investors never see, but which are critical bedrocks underlying many other financial markets. A plumbing clog that we have been writing about since mid-2019 finally backed up the pipes last week, and the visible result was wild swings in equity markets and some of the seemingly irrational trading in even high-quality bonds. The most recent round of emergency Fed action should start to unclog that plumbing and prevent financial markets from compounding the downside economic risks presented by the coronavirus.
The Fed’s liquidity announcements include $500 billion of U.S. Treasury purchases and $200 billion of mortgage-backed security purchases, known as QE. A QE package of $700 billion is certainly a strong start, but trading in many U.S. Treasury securities was nearly non-existent in recent days. To really improve market functioning, the Fed would need to front-load these Treasury buys to reduce banks’ capital ratios to allow those banks to re-initiate supply of capital to the financial markets.
QE also helps the economy in two major ways:
- it reduces the amount of risk in the market by removing long duration securities from the market, and
- it encourages investors to take incremental risk as former holders of Treasuries seek returns in other investments.
Those economic benefits generally take three to 12 months to emerge; as Ben Bernanke once said, monetary policy works with long and variable lags.
Coordinated effort by world's Central Banks
Next, the Fed took a host of other extraordinary actions to support market functioning in largely technical ways. The Fed announced expanding “swap lines” with other major central banks, including the ECB, Bank of Japan, Bank of England,
and Bank of Canada. These swap lines are designed to ensure that foreign banks have access to dollar funding and help support global banking system health. Beyond dollar swap lines, the Fed also set its required reserve ratio to zero, and “encouraged”
banks borrow cheaply from the Fed without stigma. While many market participants were hoping the Fed would buy short-term loans and bonds from private sector borrowers, they chose not to.
Despite an aggressive package of economic support and liquidity action, financial markets were not initially pleased. U.S. equity futures quickly traded down, though granted the news flow over the weekend was quite negative. In fixed income markets, two-, five-, 10-, and 30-year U.S. Treasury prices all traded moderately higher. The 10-year futures were higher by about 1.7% in price, equivalent to a roughly -0.16% decline in yield to 0.79%. As per our March 13 note, market makers have elected to withdraw capital provisioning to the financial markets. The result is extreme volatility, and overnight action may not reflect actual supply and demand when U.S. trading hours re-open Monday morning.
Monetary policy support only part of the recovery
At the end of the day,
while the Fed can provide support to the financial markets and help to ensure a quick rebound once conditions return more to normal, monetary policy is triage, not a cure, for a deeply wounded private sector. Fiscal support from Congress and the White
House can further help normalize economic conditions, but only the private sector can provide the needed capital to restore economic growth.
Bond market stress created temporary illiquidity that further complicated the session. Yesterday’s experience, however, was not inconsistent with prior periods of temporary stress. This was true in 1987 (both October 19 and October 26) and three times in 2008. It takes time for the markets to re-establish stability and return to normal market movement. We think the current market volatility likewise will take time to assess more fully the underlying conditions that produced the recent stress.
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