Following the U.S. Federal Reserve’s (Fed’s) massive stimulus announcement on Sunday, we noted that the Fed’s focus on liquidity and funding was of paramount importance. Yes, cutting interest rates to near zero is as significant as it is important, but ensuring that the U.S. Treasury and broader credit markets are functioning healthily is just as critical.
On this, there are now two positive developments:
- First, there’s evidence that the Fed’s measures are helping to calm some of the stress in the Treasury market. The FRA-OIS spread,¹ a widely used indicator to gauge banking sector risk, has fallen significantly since the Fed’s announcement on Sunday.²
- Second, what we viewed as the “missing piece” of the package—a corporate paper-buying facility—was announced Tuesday morning.³
As we’ve noted previously, we’re at a point where the economic slowdown triggered by the COVID-19 outbreak is threatening to evolve into something more systemic in nature—a credit crunch. In our view, the Fed’s focus and action on this front, as is the case with many other central banks, has been reassuring. While it isn’t likely to prevent the global economy from slipping into a recession, it can help to contain the economic damage and, crucially, prevent contagion from taking place.
The Commercial Credit Funding Facility (CCFF) is back in action and that’s very good news
Using the CCFF, the Fed’s targeting a growing problem in the U.S. commercial paper market, which trades short-term corporate debts. This market has essentially seized up. Call it a perfect storm: Banks stepped back from buying commercial paper—expecting companies to rush to raise cash—just as money market funds, typically a key buyer of these papers, turned seller in anticipation of redemptions.
Functioning of the commercial paper market is important because:
- Without support, companies would lose access to commercial paper markets, forcing them to rely more heavily on bank loans at precisely the moment when banks are looking to reduce risk on their balance sheets.
- Money market funds would be unable to sell and raise the cash necessary for them to meet redemption requests.
Loosening capital rules and ramping up quantitative easing (QE), as the Fed announced on Sunday, helps to free up bank balance sheets to a certain extent and ease concerns about corporate funding. In addition, markets have been hoping that the Fed will step in as a key buyer of commercial paper in the belief that it’ll calm the market.
For context, this isn’t a radical decision for the Fed—it created a commercial paper funding facility in 2008⁴ and has now brought it back to life.
Here’s how it works: The Fed creates a special purpose vehicle (SPV) that buys corporate paper from eligible issuers (it can’t purchase these assets directly in the market because the Federal Reserve Act only allows the Fed to buy Treasuries and asset-backed securities, or ABS). Commercial papers purchased through the facility will remain in the SPV until they mature, at which point the proceeds will be used to repay the original loan taken out by the New York Federal Reserve. Tuesday’s announcement says the CCFF will purchase A1/P1-rated corporate paper beginning March 17 for one year.¹ Note that the Fed can only lend to solvent entities, but a US$10 billion exchange stabilization fund is in place that can absorb any losses and keep the SPV solvent (as long as the losses don’t exceed US$10 billion).
In our view, the announcement should help to inject some calm into some parts of the credit market and encourage the perception that the Fed can indeed contain the knock-on effects to credit from the coming recession. Although it doesn’t completely eliminate the stress within the market and how it’s implemented will be key, we believe it will support market functioning, perhaps significantly.
What's next from the Fed?
We’ve seen rate cuts, QE, liquidity injections, U.S. dollar swap lines, interest-rate cuts to the discount window, forward guidance, cuts to the discount rate, the CCFF… has the Fed run out of tools?
No, not in our view. We believe there’s plenty of potential for the Fed to do more, including (but not limited to):
TALF: A variation of the 2008 Term Asset-Backed Securities Lending Facility (TALF) is an option. TALF operates like a discount window, which enables banks to borrow directly from the Fed, but allows the Fed to accept a much bigger range of collateral (i.e., not just Treasuries or agency-backed mortgage-backed securities).
In 2008, it was used to restart the consumer asset-backed securities market. A variation of the initiative could be used in a similar way, with nonrecourse loans secured by corporate credit as the underlying collateral.
Yield curve control (YCC): The Fed can engage in YCC, just as the Bank of Japan did in 2016. Put simply, the Fed would target a longer-term rate and buy/sell long-term bonds to keep that rate pinned to a certain level, thereby controlling the shape of the yield curve. Many current and previous Fed officials, including current Fed Governor Richard Clarida, along with former Fed Chairs Ben Bernanke and Janet Yellen, have voiced support for this type of policy.⁵
Credit easing or buying stocks and ETFs: We don’t think the Fed will need to move toward buying credit, stocks or exchanged-traded funds (etfs)—the probability is low—but it remains possible. Although the Federal Reserve Act only allows the Fed to buy Treasuries and ABS, Congress could rewrite the law, like it did in 1933 (it took them four weeks then; it could be less now).
Amending the Federal Reserve Act will require the support of both the House and the Senate and will ultimately require the approval of the U.S. president.
On March 15, Chair Jerome Powell said that the Fed isn’t currently pursuing amendments to the Federal Reserve Act (“It’s not legal authority that we’re seeking,” he said),⁶ but we believe it remains a possibility if markets were to fall further.
What we should NOT expect: negative interest rates
Chair Powell was very clear: “We do not see negative policy rates as likely to be an appropriate policy response here in the United States,” he said on Sunday.⁶ The vast amount of research undertaken by the Fed also suggests that there’s a long list of tools available, including what we’ve listed above, which would be considered before it would think about negative interest rates. Besides, there’s limited evidence showing that negative rates can support growth, not to mention the long list of associated negative side effects.
We don’t expect negative interest rates in this cycle.
1 Mathematically, the FRA-OIS spread is the difference between 3-month LIBOR (the interbank lending rate) and the overnight index rate, or the risk-free rate, which is set by central banks. It’s widely used to gauge whether banks will be able to borrow cheaply in the future. 2 Bloomberg, as of March 17, 2020. 3 “Federal Reserve Board announces establishment of a Commercial Paper Funding Facility (CPFF) to support the flow of credit to households and businesses,” federalreserve.gov, March 17, 2020. 4 Commercial Funding Paper Facility, federalreserve.gov, February 12, 2016. 5 “What is yield curve control,” Brookings Institution, August 14, 2019. 6 “FOMC Press Conference Call,” federalreserve.gov, March 15, 2020.
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