The U.S. Federal Reserve (Fed) has gone all in. The U.S. central bank has expanded its existing tools, added an array of new ones, and, critically, has said it’ll step in to support the corporate and municipal bond markets directly.
The announcement is historic: The Fed had previously supported the commercial paper market in 2008, but it didn’t engage with the corporate or municipal bond market directly. It now joins the Bank of England, the European Central Bank, the Bank of Japan, and the Bank of Canada in a seemingly coordinated effort to support the corporate bond market.
In our view, the Fed’s latest decision should help to compress spreads for corporate bonds, asset-backed securities, mortgage-backed securities (MBS), and other credit instruments, and will provide these markets with much-needed support that ensure that they can function in a healthy manner. Those familiar with our views will know that we see addressing the dysfunction in credit markets as a necessary (although insufficient) condition for risk assets to rally. We believe these actions from global central banks—regardless of whether they’re coordinated—should help to ease those concerns.
Why this package is so significant
Even though we feel the package still has some missing pieces, the Fed has finally delivered what it needed to (in today’s context). Here’s a summary of the most important elements of Monday’s announcement:
- The Fed can now buy corporate debt through a special purpose vehicle.² The central bank has never done this before and is now attacking the problem of deteriorating credit liquidity with both a primary and secondary facility. These facilities can be used for investment-grade credit and will provide bridge financing for four years. As we wrote on March 20, we consider this to be the most important policy move we could get from the Fed. By decisively moving to support the corporate debt market, it has—in our view—reduced the likelihood of a financial crisis from taking place.
- The Fed can now buy high-quality municipal debt with maturities of up to 12 months.³ This is different from the previous facilities that limited loan maturity to 6 months. As we highlighted previously, this is a market segment that’s experienced significant stress and will likely benefit from the announcement.
- The Fed can now buy ETFs, with some limitations. The Secondary Market Corporate Credit Facility may “purchase U.S.-listed exchange-traded funds (ETFs) whose investment objective is to provide broad exposure to the market for U.S. investment grade corporate bonds.” ² The Fed can buy up to 20% of any ETF⁴—this is equivalent to putting a “bid” under certain investment-grade corporate bond ETFs and, hopefully, could solve some of the dislocation between the prices of these fixed-income ETFs and their underlying net asset value.
- Quantitative easing (QE) is now unlimited. Long gone are the days when Fed Chair Jerome Powell tried to describe asset purchase programs as “not QE.” In addition, the Fed has done away with putting any sort of number on the amount of U.S. Treasuries and MBS purchases to come. On March 15, the Fed said it’d buy “at least” US$500 billion’s worth of U.S. Treasuries and US$200 billion of MBS.⁵ The new statement says it’ll purchase “in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions and the economy.”¹ In theory, this should support the mortgage market where rates have been rising and keep Treasury yields low.
- Commercial real estate MBS is now included in the Fed’s open-ended QE. Previously, only residential MBS were included.²
- The Term Asset-Backed Securities Loan Facility is back. The facility, widely known as TALF, was first introduced in 2008, backs all kinds of consumer debt, and should support the household sector debt channels. This segment of the market isn’t currently a problem but could become one. Collaterals that are eligible for this facility include auto loans, student loans, credit card receivables, and insurance premium finance loans, among others.⁶
- The Fed is to provide support for small- and medium-sized businesses. The Fed said it expects to announce a Main Street Business Lending Program that’ll provide lending to smaller businesses.² Details are still unknown, but that is also a new and important development.
What should the Fed do next?
- We think the Fed will need to make adjustments to some of its programs—much of this is new to the Fed and some fine-tuning will be required. For instance, the Fed will probably need to amend one particular element of its Corporate Credit Funding Facility: In its current set up, the Fed accepts issuers with a credit rating of at least BBB-/Baa3. This suggests an issuer could lose access to the facility if its rating is downgraded below the Fed’s set criteria. We believe the Fed may need to adjust to something more akin to the Bank of England’s corporate debt program, which bases eligibility on the issuer’s rating pre-virus shock.⁷
- We continue to believe that the Fed will eventually introduce “yield curve control” to pin the front end of the curve (possibly the two-year yield).
- The TALF may be expanded to include additional securities such as collateralized debt obligations, leveraged loans, collateralized loan obligations, and nonagency commercial MBS.
- We believe the Fed might need to expand its TALF program and its two corporate bond facilities; the Fed has currently allocated US$300 billion to these three facilities. Should Congress approve an expansion to these facilities, then the Fed’s ability can be greatly enhanced.
Overall, the Fed’s announcement is encouraging. While it isn’t likely to solve all of the problems confronting the U.S. economy, it goes a long way to removing an important tail risk that had been developing—the likelihood of a credit crunch is now much reduced.
1 “Federal Reserve issues FOMC statement,” federalreserve.gov, March 23, 2020. 2 “Federal Reserve announces extensive new measures to support the economy,” federalreserve.gov, March 23, 2020. 3 “Term Sheet: Money Market Mutual Fund Facility,” federalreserve.gov, March 23, 2020. 4 “Secondary Market Corporate Credit Facility,” federalreserve.gov, March 23, 2020. 5 “Federal Reserve issues FOMC statement,” federalreserve.gov, March 15, 2020. 6 “Term Sheet: Term Asset-Backed Securities Loan Facility,” federalreserve.gov, March 23, 2020. 7 “Covid Corporate Financing Facility (CCFF),” Bank of England, March 20, 2020.
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