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Economic Insights

In my opinion, the U.S. markets are waiting for a vigorous fiscal response to the coronavirus impact as there are still many things monetary policy alone cannot fix.

In response to the rapidly spreading COVID-19 virus and its negative impact on the U.S. economy, the U.S. Federal Reserve (Fed) on Sunday, March 15, 2020, held its second emergency meeting of the month.

At the first meeting, on March 3, the Fed had lowered the fed funds rate by 50 basis points (bps).

After the second meeting, the Fed announced it was lowering the rate again to zero, restarting quantitative easing with the purchase of government bonds and mortgage-backed securities (MBS), and opening foreign exchange swap lines with other major central banks.  

What Just Happened?
On March 16, U.S. markets responded with sharp losses, the extent of which, in some cases, had not been seen since the 1987 crash.

In fairness to the Fed, after a weekend in which  Western Europe had, for all practical purposes , shut down and New York City had  closed schools and restricted the operations of restaurants, a market selloff had become almost inevitable, even without a Fed meeting.

The nation is face to face with a fast-moving health crisis that is unlike the 2008-09 financial crisis, and I believe we are likely to see continued Fed innovation going forward, such as the possible use of yield curve control.

But, I believe the market is waiting on a vigorous fiscal response too, as there are still many things monetary policy alone cannot fix.

Using an Old Playbook
In many ways, the Fed is using an old playbook from the financial crisis of 2008-09 – applying lessons learned then to areas where it has some control, for example in fixing the degraded market-making in the U.S. Treasury market.  In other ways, the Fed is innovating slightly, such as lowering the cost of the discount window and the creation of dual interest rates. (See later discussion of both issues.)

Most importantly, the Fed is moving to make sure the pipelines of the market are flowing as best as possible given the large and rapid de-risking and deleveraging of recent weeks.  

In my estimate, the major problems (not the only problems) cropping up in the financial system have been the following:

  1. A widening of the cross-currency basis: A cross-currency basis swap agreement is a contract in which “Party A” borrows one currency from “Party B” and simultaneously lends the same value, (at current spot rates) of a second currency to “Party B.” The parties involved in basis swaps tend to be financial institutions, either acting on their own or as agents for non-financial corporations.
  2. A widening spread between on-the-run (recently issued) and off-the-run U.S. Treasuries: In times of great pressure to lower risk, asset managers may be selling more liquid Treasuries first, thus creating a bigger spread between the price of similar-maturity Treasuries. This spread captures the yield investors forego in order to hold the most recently issued 10-year Treasury note.  (In another metric of the same pressure, the error from standard quantitative fits of the yield curve, like a spline curve1 fit, also showed increasing liquidity problems.)
  3. The shrinking working capital of firms: When activity vanishes, a business must rely on working capital or available borrowing – be it short-term loans or short-term borrowing on markets like commercial paper – to bridge itself to the end of the slowdown.

The Fed’s Recent Actions

 

Chart 1. Foreign Exchange Markets Also Showed Funding Stress
JPY-USD Basis Swaps (3M vs 3M IBOR) 3M (March 18, 2019–March 16, 2020)

 

Source: Bloomberg.

 

The foreign exchange (FX) swap lines created by the Fed help ease the shortage of U.S. dollars in global currency markets. The Fed essentially expands the supply of available dollars to foreign central banks through the swap line. The foreign central banks in turn use the extra supply to alleviate their banks’ funding. At its recent meeting, the Fed also lowered the rate it charges on these swap lines.

Quantitative easing, in particular the purchases of Treasuries (which started in part on Friday, March 13 and were greatly expanded on Sunday, March 15) and of MBS should help improve liquidity in bond markets and address the on-the-run / off-the-run spread. It is unclear if that is happening as of this writing (March 17), but at least things appear to be not deteriorating further.  Depending on the length of the shock, a considerable period of quantitative easing may be required.

 

Chart 2. Serious dislocations in Treasury market-making warranted Fed action
U.S. Government Securities Liquidity Index (GVLQUSD) * (March 18, 2015–March 16, 2020)

 

Source: Bloomberg. *The Index GVLQUSD is a measure of prevailing liquidity conditions in the U.S. Treasury market. This Index displays the average yield error across the universe of U.S. Treasury notes and bonds with remaining maturity of one-year or greater, based off the intra-day Bloomberg relative value curve fitter. Yield error is the difference between the yield curve estimated through a quantitative method and the actual yield.

 

In addition, to address the availability of loans, the Fed lowered the spread at the discount window by 50 bps, eliminated reserve requirements, and lowered capital and liquidity requirements. In some ways the discount window action is comparable to the European Central Bank’s TLTRO (Targeted Long-Term Refinancing Operations) in the sense that the discount rate becomes a second measure of independent stimulus along with the fed funds rate (a so-called “dual rates” system).

All of these bank-related measures are a somewhat indirect method of improving businesses’ access to credit – to the extent banks feel more free from capital buffers and have lower costs they can provide new loans, but they will remain reluctant to lend to everyone if there is significant risk of default.

Fiscal Powers
On this latter point there is an important role for the fiscal powers of the federal government. An example is Germany, which recently announced that it would provide unlimited low-cost credit to businesses through its state development bank (KfW), formerly known as Kreditanstalt für Wiederaufbau.

The United States does not have a state development bank, but Congress may still act to do something similar and this might help activity bounce back in a meaningful way as it directly addresses the nature of the shock currently facing the U.S. economy. But implementation issues are likely to abound as large-scale lending to a multitude of small firms, all in a short amount of time, has not been attempted before.

A Commitment to Low Rates
The Fed is unlikely to turn to negative rates for stimulus, in my opinion, but it may engage in a firm commitment to low rates for a long time (“forward guidance”) that is backed up by fixing the rate of long-term yields through unlimited bond purchases (“yield curve control” as first practiced by the Bank of Japan).

Lender of Last Resort
The last ace up the Fed’s sleeve is its 13(3) authority under the Federal Reserve Act, which allows it to start using crisis-era facilities like the Term Asset-Backed Securities Loan Facility or the Commercial Paper Funding Facility. These facilities target credit stress directly – the Fed essentially steps in as a lender of last resort to corporations in these particular credit markets and also provides help by accepting many forms of credit as collateral.

The Fed has embraced innovation and policy flexibility in previous crises. The challenge of COVID-19 will provide a fresh test of policymakers’ creativity and agility.

 

1 The Treasury's yield curve is derived from bid-side market quotations (not actual transactions) for the on-the-run securities obtained by the Federal Reserve Bank of New York at or near 3:30 PM each trading day. Because the on-the-run securities typically trade close to par, those securities are designated as the knot points in the quasi-cubic hermite spline algorithm and the resulting yield curve is considered a par curve. (https://home.treasury.gov/policy-issues/financing-the-government/interest-rate-statistics/treasury-yield-curve-methodology).

 

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. U.S. Treasuries are debt obligations issued and backed by the full faith and credit of the U.S. government. Income from Treasury securities is exempt from state and local taxes. Although Treasuries are considered to have low credit risk, they are affected by other types of risk—mainly interest rate risk (when interest rates rise, the market value of debt obligations tends to drop) and inflation risk.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary of Terms

basis point is 1/100 of a percentage point.

The Commercial Paper Funding Facility (CPFF) was created by the U.S. Federal Reserve to provide a liquidity backstop to U.S. issuers of commercial paper. The CPFF was intended to improve liquidity in short-term funding markets and thereby contribute to greater availability of credit for businesses and households. Under the CPFF, the Federal Reserve Bank of New York financed the purchase of highly rated unsecured and asset-backed commercial paper from eligible issuers via eligible primary dealers. The CPFF began operations on October 27, 2008, and was closed on February 1, 2010.

The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions.

The federal funds rate (fed funds rate) is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight.

“On-the-run” Treasuries are the most recently issued U.S. Treasury bonds or notes of a particular maturity. "On-the-run" Treasuries are the opposite of "off-the-run" Treasuries, which refer to Treasury securities that have been issued before the most recent issue and are still outstanding.

Quantitative easing (QE), also known as large-scale asset purchases, is a monetary policy whereby a central bank buys predetermined amounts of government bonds or other financial assets in order to add money directly into the economy.

The spread is the gap between the bid and the ask prices of a security or asset, like a stock, bond or commodity.

The Term Asset-Backed Securities Loan Facility (TALF) was a funding facility that helped market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities (ABS) collateralized by loans of various types to consumers and businesses of all sizes. The TALF began operation in March 2009 and was closed for new loan extensions on June 30, 2010. The final outstanding TALF loan was repaid in full in October 2014.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

The yield curve is a curve showing several yields to maturity or interest rates across different contract lengths for a similar debt contract. The curve shows the relation between the interest rate and the time to maturity, known as the "term," of the debt for a given borrower in a given currency.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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