March 15, 2020 — The Federal Reserve surprised markets again and took emergency measures on Sunday night, March 15, including cutting rates to zero and a plan to purchase $700 billion worth of Treasuries and mortgages in the coming months. Late in the day the Fed announced the Federal Open Market Committee (FOMC) conducted an emergency meeting in lieu of their scheduled meeting later in the week. In addition to the rate cut and purchases, they took a series of actions, detailed below, that were aimed at two goals: 1) ensuring the functioning of financial markets, and 2) encouraging banks to lend to households and businesses as the response to the virus increasingly threatens the economy. These actions are massive, and we believe will be supportive to the functioning of markets and the economy. They are necessary, but not sufficient, to keep the economy from sliding into an extended downturn. Ultimately the success of the disease mitigation effort and the federal fiscal response will be critical in the outcome.

The Fed cut the target range for the federal funds rate, to a range of essentially zero, at 0%-0.25%. After the surprise cut of 50 basis points, or 0.5%, on March 3, this means they’ve cut by 1.5% in less than two weeks. Combined with the three cuts from 2019, the Fed has now undone in 8 months the stepwise rate hikes that they had done over several years (Figure 1). Cutting rates in the current environment was necessary given the threat to economic growth as well as the inverted yield curve. As we detailed two weeks ago, the inverted curve amounts to very bearish sentiment about growth and the bond market pushing the Fed into a corner to cut rates.

 

Liquidity and Market Functioning

To ensure market functioning, the Fed also announced they would be purchasing $500 billion of Treasury Securities and $200 billion of mortgage-backed securities (MBS) in the near future. This is a return to so-called Quantitative Easing (QE), and will be the fourth such round and will push up the Fed’s balance sheet to new highs (Figure 2). The stated reason for the purchases is to ensure the smooth functioning of financial markets. In the press conference that followed tonight’s announcement, Chair Powell focused significantly on disruptions in both the Treasury and MBS markets in recent volatile weeks.

Along with other market participants, we noticed odd phenomena in market pricing last week, most notably the upward drift of the 10-year Treasury yield while equity markets were moving sharply downward. In a typical risk-off market, investors are selling equities and moving into the safe-havens of long-dated Treasuries and should be pushing down those yields. The best explanation is strained liquidity in the market, observable in a divergence of the bidding and asking prices by participants in the market. Powell confirmed that despite some smaller efforts from the Fed last week, liquidity for Treasuries is strained. (Last week’s efforts included a massive liquidity program for the overnight repo market, which has been on the radar for months.) The mortgage market was also showing strains, with spreads on MBS widening against Treasuries.

Figure 1: Federal Reserve Target Rate Upper Bound (%)

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As of March 15, 2020. Source: Federal Reserve

 

The second action directed at market functioning was a coordinated action with other major central banks (Bank of Canada, the Bank of England, the Bank of Japan, and the European Central Bank) to ensure the availability of dollars in international markets. Specifically, they agreed to lower the pricing on U.S. dollar swap arrangements and also offer long-term arrangements.

Encouraging Banks to Lend

It has become clearer by the day that the health and government response to COVID-19 will have a detrimental effect on the economy. The obvious initial casualties are the cruise line, airline, and hotel industries as travel and conferences have been curtailed. As news continued to pour in about festivals, professional sports, and school closures, the expected impact has only worsened and been pushed further out on the calendar. With the most recent news on Sunday night that the Centers for Disease Control is recommending no gatherings of more than 50 people for eight weeks, it is clear that the impacts will be long lasting. Businesses of all kinds and sizes will be hard-pressed to collect revenue but will be faced with ongoing costs and decisions about what to cut, including employees.

The Fed took several actions to encourage banks to lend to households and businesses in this challenging time. First, it is explicitly saying banks should use their capital and liquidity buffers which are built up in good times specifically in preparation for the rainy days. The Fed noted the largest banks have $1.3 trillion in common equity and $2.9 trillion in high-quality liquid assets (HQLA). Banks are sometimes uncertain about how the Fed or other regulators will react if their buffers drop. In this instance, the Fed is saying as loudly as they can that these sources can be used.

Additionally, the Fed completely removed the requirement for banks to hold reserves against deposits, reducing the required reserve ratio to zero. This unlocks roughly $151 billion that, until today, banks were required to hold in their accounts at the Fed.

Lastly, the Fed reduced the rate for banks that come to the Fed for an overnight loan, known (confusingly) by two names, as the discount rate and the primary credit rate. Essentially, when banks need an overnight loan they first approach a fellow bank. If they come up dry then they come, hat in hand, to the Fed for the overnight loan. In normal times they pay a premium and also get a wag of the finger from the Fed, increasing the likelihood of scrutiny at their next regulatory exam. Today, the Fed said loudly that it will not wag the finger, and also waived the premium.

Core Narrative

The Fed’s actions today are indicative of the scale of the problem, and are necessary but not sufficient to stop the U.S. economy from sliding into a prolonged downturn. We had already moved to an expectation of a decline in economic activity in the second quarter, and had moved to an underweight to equities last month. The growing scale of the COVID-19 crisis and the response have only worsened the outlook. It is compounded by the recent collapse in oil prices due to weak demand and a spat between Saudi Arabia and Russia. The Fed’s actions taken today will help the functioning of financial markets and provide support to the economy. But its ability to promote growth is limited. It can only work through the banking system by offering liquidity and lower rates, but cannot force banks to lend and cannot give funds directly to other sectors of the economy. Ultimately, the path of the economy will hinge greatly on the extensiveness of mitigation measures to prevent the spread of COVID-19, as well as the federal fiscal policy response. We continue to recommend the underweight to equities, and will update our assessment as the federal response takes form.

 Figure 2: Federal Reserve Total Balance Sheet Assets ($ trillions)

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As of March 15, 2020. Source: Federal Reserve, Bloomberg, WTIA

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