The Federal Open Market Committee (FOMC) "unleashed the beast" Monday morning, announcing open-ended (i.e., unlimited) quantitative easing (QE), as well as several additional programs designed to restore smooth market functioning and effective transmission of monetary policy to various financial conditions.
Namely, the FOMC will continue its ongoing purchases of US Treasury securities, agency-guaranteed mortgage-backed securities (MBS), expanding MBS to include agency-guaranteed commercial mortgage-backed securities (CMBS), and the financing of up to $300 billion of investment grade credit and asset-backed securities (ABS).
This expansion of the FOMC's monetary policy signals that the FOMC is prepared to do everything in its power to help stabilize financial markets, and willing to utilize every tool in its toolbox to do so. This is a very positive development. Invariably, while this action by the FOMC won't prevent the economic contraction resulting from coronavirus containment efforts (or help stop the virus itself), it significantly increases the odds of the financial markets stabilizing, particularly related to liquidity and the ability of firms to access credit. This is an incredibly important development.
Our confidence in this statement comes from the work of Irving Fisher (1867 – 1947). Fisher wrote extensively about the depression and the debt-deflation spiral exhibited during that time. One of his hallmark papers on this topic can be found on the St. Louis Fed's website. While his paper contains a tremendous amount of useful and pertinent information, and we encourage everyone to read it, two things he writes about appear to be especially salient and prescient for our time.
In the first, he likens the US economy to a ship at sea. Normally, when buffeted by waves, the ship may rock back and forth, but its natural tendency is to right itself (i.e., a normally functioning economy experiencing expansions and contractions). However, if a ship is rocked by a wave large enough, and it tips far enough, its natural tendency is not to right itself, but to capsize (i.e., economic collapse resulting in a depression).
Fisher goes on to describe the ingredients related to the "capsizing" of an economy:
- Debt liquidation and distress selling
- Contraction of the money supply as bank loans are paid off
- A fall in the level of asset prices
- A still greater fall in the net worth of businesses, precipitating bankruptcies
- A fall in profits
- A reduction in output, in trade and in employment
- Pessimism and loss of confidence
- Hoarding of money
- A fall in nominal interest rates and a rise in deflation-adjusted interest rates
While the order of these events may not precisely hold, current market expectations appear to reflect many of these ingredients.
The Federal Reserve is, if nothing else, a student of history, and they appear to grasp Irving Fisher's thesis. Monday's activities appear to be a direct attempt to:
- Increase the base supply of money via the printing-press component of QE
- Increase the level of asset prices via its direct purchases of US Treasurys and agency MBS/CMBS
- Stem the tide of debt liquidation and distress selling via Federal Reserve Act section 13(3) purchases
- Restore confidence via its commitment to, "Doing whatever it takes."
While these actions by the FOMC may not bring about a sharp rebound in equity or fixed income valuations, we believe it represents a pivotal moment that is likely to slow, and eventually stop the economy from hurtling towards self-destruction. Of course, this doesn't mean there won't be additional volatility and a period where valuations remain suppressed, but it does remind us of a quote by another historical figure, Winston Churchill, "Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning." We have every reason to believe will be is the case.
A summary of the additional FOMC's actions announced:
- Removal of the previously-announced $500 billion cap on the purchases of US Treasury securities and $200 billion cap of MBS.
- Expansion of purchases to include agency-guaranteed CMBS in its open-ended QE program.
- Establishment of two facilities to support credit to large employers: the Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds.
- The PMCCF will be open to investment grade companies and will provide bridge financing of four years. Borrowers may elect to defer interest and principal payments during the first six months of the loan, extendable and the Federal Reserve's discretion, in order to have additional cash on hand to pay employees and suppliers.
- The SMCCF will purchase in the secondary market corporate bonds issued by investment grade US companies and US-listed exchange-traded funds (ETFs) whose investment objective is to provide broad exposure to the market for US investment grade corporate bonds.
- The Federal Reserve will finance two special purpose vehicles (SPVs), established under section 13(3) of the Federal Reserve Act, to make loans from the PMCCF to companies; and in the case of the SMCCF, to make secondary market purchases of corporate bonds and corporate bond ETFs. The Treasury, using the Exchange Stabilization Fund (created by the Gold Reserve Act of 1934), will make an equity investment in these SPVs.
- Establishment of a third facility, the Term Asset-Backed Securities Loan Facility (TALF), to support the flow of credit to consumers and businesses. The TALF will enable the issuance of ABS backed by student loans, auto loans, credit card loans, loans guaranteed by the Small Business Administration (SBA), and certain other assets.
- Expansion of the Money Market Mutual Fund Liquidity Facility (MMLF) to include a wider range of securities, including municipal variable rate demand notes (VRDNs) and bank certificates of deposit.
- Under the TALF, the Federal Reserve will lend on a non-recourse basis to holders of certain AAA-rated ABS backed by new and/or recently originated consumer and small business loans. The Federal Reserve will lend an amount equal to the market value of the ABS less a haircut, again using a 13(3) SPV.
- Expansion of the Commercial Paper Funding Facility (CPFF) to include high-quality, tax-exempt commercial paper as eligible securities. Additionally, the FOMC reduced the pricing of this facility.
- The announcement of a soon-to-be-established Main Street Business Lending Program to support lending to eligible small-and-medium sized businesses, complementing efforts by the SBA.
This material is to be used for institutional investors and not for any other purpose. This communication is being provided for informational purposes in connection with the marketing and advertising of products and services. This material contains current opinions of the manager and such opinions are subject to change without notice. Aegon AM US is under no obligation, expressed or implied, to update the material contained herein. This material contains general information only on investment matters; it should not be considered a comprehensive statement on any matter and should not be relied upon as such. If there is any conflict between the enclosed information and Aegon AM US' ADV, the Form ADV controls. The information contained does not take into account any investor's investment objectives, particular needs, or financial situation. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to you. The value of any investment may fluctuate. Investors should consult their investment professional prior to making an investment decision. Aegon AM is not undertaking to provide impartial investment advice or give advice in a fiduciary capacity for purposes of any applicable federal or state law or regulation. By receiving this communication, you agree with the intended purpose described above.
The information presented is for illustrative purposes only.
Aegon AM US may trade for its own proprietary accounts or other client accounts in a manner inconsistent with this report, depending upon the short term trading strategy and/or guidelines for a particular client as well as other variables.
Diversification does not ensure a profit nor guarantee against loss.
This document contains "forward-looking statements" which are based on the firm's beliefs, as well as on a number of assumptions concerning future events based on information currently available. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance and actual outcomes and returns may differ materially from statements set forth herein.
Aegon Asset Management US is a US-based SEC registered investment adviser and is also registered as a Commodity Trading Advisor (CTA) with the Commodity Futures Trading Commission (CFTC) and is a member of the National Futures Association
(NFA). Aegon Asset Management US is part of Aegon Asset Management, the global investment management brand of the Aegon Group.
Recipient shall not distribute, publish, sell, license or otherwise create derivative works using any of the content of this report without the prior written consent of Aegon Asset Management US, 6300 C Street SW, Cedar Rapids, IA 52499. © 2020 Aegon Asset Management US. AdTrax: 2979175.3. Exp Date 03/01/2022.