The FOMC Unleashes the Beast

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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:

  1. Debt liquidation and distress selling
  2. Contraction of the money supply as bank loans are paid off
  3. A fall in the level of asset prices
  4. A still greater fall in the net worth of businesses, precipitating bankruptcies
  5. A fall in profits
  6. A reduction in output, in trade and in employment
  7. Pessimism and loss of confidence
  8. Hoarding of money
  9. 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:

  1. Increase the base supply of money via the printing-press component of QE
  2. Increase the level of asset prices via its direct purchases of US Treasurys and agency MBS/CMBS
  3. Stem the tide of debt liquidation and distress selling via Federal Reserve Act section 13(3) purchases
  4. 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.

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Calvin Norris, CFA

About Calvin Norris, CFA

Calvin Norris, CFA, is a rates strategist responsible for guiding the firm's interest rate strategy. He is also a portfolio manager responsible for the overall strategy, portfolio management and trading of money market, short-term cash, ultra short duration, government bond and US Treasury Strips portfolios.