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MACRO WRAP-UP

We Interrupt Your Regularly Scheduled Fed Programming

April 17, 2020

If you’ve found the Fed’s recent actions confusing, you are not alone. The sheer volume of what has been done, the complexity of the
programs, and the Fed’s choice of names has made them almost impossible to follow. Not only has the Fed boldly tested the limits of its
mandate, but it has also tested the limits of the English alphabet. MMLF, SMCCF, PMCCF. These acronyms seem designed to be
forgotten. 1 Perhaps the Fed is telling us that it is taking the crisis so seriously that its program-naming department has been repurposed
to help in the effort.

In a normal economic environment, the Fed doesn’t need to create any of these fancy programs. For most of the past thirty years, the Fed
has used a simple tool to achieve two broad economic goals. It has tried to influence inflation and employment by adjusting the rate at
which banks lend to each other overnight. However, the extreme slowdown in economic activity makes it impossible to achieve anything
resembling maximum employment or stable prices in the near term. The Fed has been forced to change both its goals and its tools.

A shift in strategy is by no means unprecedented. For example, during and after World War II, the government tasked the Fed with
maintaining low interest rates on the war debt. 2 There have been several times in which the Fed has shifted from its mandate to focusing
on ensuring financial stability.3 Right now, the Fed is acting as a crisis manager. While it can’t do anything about the health crisis, it is
trying to prevent the enormous drop in activity from becoming a financial and economic crisis.

Members of the Fed think it needs to do two things to achieve these goals. First, it needs to ensure that markets can function properly.
Second, it needs to ensure that the economy can function at all. While these sound painfully obvious, they are profoundly difficult to
achieve. The shutdowns have displaced enormous numbers of workers and businesses. If too many businesses are shuttered, the
economy can’t return to past levels even in a best-case scenario in which the health crisis ends quickly. The Fed can’t bring the economy
back into equilibrium so long as activity is stopped, but its members think it can create the conditions for it to return in the future.

In the absence of a single perfect tool, the Fed has instead enacted a series of increasingly aggressive measures. It started with
conventional measures such as cutting its target rate to zero and adding to its repo facilities.4 It eased enforcement of some regulations.
That wasn’t enough to stabilize markets so the Fed announced it would buy 700b of Treasury Bonds and Agency MBS. While QE may
have seemed unorthodox twelve years ago, it has now become a very common tool for central banks around the world. But sadly, its
acceptance has not made it effective. Even the safest of markets, U.S. Treasuries, remained dysfunctional. The Fed then revived swap
lines with other major central banks and made the QE unlimited in size.5 These measures were enough to bring back some stability in
government bonds and foreign exchange markets, but other markets remained far from normal.

As the crisis worsened, investors avoided credit risk in almost any form. Corporate and municipal lending was essentially frozen. The Fed
was aware that no amount of purchases of government bonds could fix that, but it faced legal and regulatory obstacles to additional action.
The Fed is restricted from taking credit risk to prevent it from picking winners and losers in the economy. And perhaps to stop it from losing
money.6To get around this, the Fed created facilities to support these markets with the help of the Treasury department. The Treasury
provided equity for these facilities from its stimulus package budget.7 These facilities can buy assets with up to 10x leverage provided by
the Fed. Any credit losses will come out of the capital the Treasury put in.8

These facilities started with corporate bonds, but later added municipal bonds and packaged loans.9 But the Fed felt even this was not
enough; it had at least one surprise left. Previously, in joint programs with the Treasury, the Fed was careful to buy only investment grade
assets.10Earlier this month, the Fed abandoned that restriction. Its facilities can now directly buy high yield bonds so long as they were
investment grade back on March 22, which happens to be the date when they started the programs.11 The facilities can also buy high yield
ETFs which can hold a variety of sub-investment grade issues.12

This may seem like a natural progression, but it is actually a very bold step for a central bank which until last month avoided buying credit
instruments. It goes beyond just stabilizing specific markets. The Fed is trying to tell investors and business that it is not afraid to use any
tool it can think of to stabilize markets, and that it will continue for as long as it feels it needs to. One of the criticisms of other central banks
facing severe deflationary pressure was that they were too timid to use their unlimited firepower. The Fed members may be channeling
Miley Cyrus by telling us that they can’t stop. They won’t stop. Based on recent moves in these markets, it seems that the sellers may have
finally gotten tired of listening to it.

During the last financial crisis, a number of folks criticized the Fed for overstepping. Perhaps the most stinging of the critiques was that the
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Fed was making the financial system riskier by creating moral hazard. The core of this argument is that if the Fed helps banks and other
failing businesses to survive, these entities are encouraged to act even more irresponsibly because of the implied safety net. These same
critiques are being made now, but they don’t seem as prevalent. Perhaps because this has been a global health crisis, people view the
economic problems as the result of bad luck rather than the bad behavior of companies. The Fed seems to be taking as much criticism for
being too narrow in its support as it is for overstepping.13 Still, the Fed’s actions are far more potent this time. It isn’t quite throwing money
out of helicopters, but it’s the closest the Fed has come in recent memory. Purchases of corporate bonds are very different from
purchases of Treasuries. They reduce the amount of available risky assets and make credit cheaper in public markets. This credit easing
can move markets significantly and affect the economy. The initial effects are usually positive for asset prices. Longer-term, it could create
bubbles or inflation. Right now, that probably won’t affect pricing, because markets can’t seem to look further than the end of the crisis.

What We Are Watching

Manufacturing and Services PMIs in the U.S., Eurozone, and U.K. (Thursday)
This week, Markit will publish its preliminary April PMI results for the U.S., the Eurozone, and the U.K. PMIs are calculated based on the net
proportion of survey respondents seeing growth vs. contraction in dimensions of their business such as production, employment, and new
orders. While different countries implemented lockdowns at different times, nearly all large countries had imposed significant restrictions on
public gatherings and various types of business operations by the end of March. As a result, PMIs based on in early April will likely show
the broadest weakness in manufacturing and service sector activity of the current downturn. If coronavirus containment efforts continue to
show progress and restrictions begin to loosen in some places, the April readings may mark the low point for the PMIs, after which the pace
of stabilization and recovery will become the key focus for market participants.

U.S. Initial Jobless Claims (Thursday)

Approximately 22 million workers have filed initial jobless claims in the U.S. in the past four weeks. The sudden stop of the economy
following lockdowns in most states to contain the spread of COVID-19 has produced the steepest increase in jobless claims in data going
back over 50 years. The data paints a bleak picture of the labor market in the near term, but the persistence of the downturn remains
uncertain. Weekly jobless filings have decelerated in the past two weeks, but continue to be orders of magnitude larger than the pre-
lockdown levels of early March. Jobless claims are highly reliable high-frequency data on the state of the labor market, as such, market
participants will continue to monitor the weekly changes to assess the degree of stabilization in employment in the weeks ahead.

U.S. UMich Consumer Sentiment (Friday)

Unsurprisingly, consumer sentiment has taken a big hit in recent weeks. The Consumer Sentiment Index produced by the University of
Michigan experienced its largest monthly decline since 2005 in preliminary data for April. Next week, the market will get another update on
consumer sentiment as U. of Michigan will release final numbers for the month. Broad-based declines in retail sales data released this
week as well as record-breaking increases in jobless claims bode poorly for these consumer sentiment figures.

[ 1 ] Still I prefer awkward acronyms to the not so subtle titles like the CARES Act.

[ 2 ] It’s difficult even to articulate what the Fed’s goals were prior to World War II.

[ 3 ] It is possible to argue that financial stability is just a way to achieve stable inflation and maximum employment. After all, a financial crisis
would meaningfully affect these economic variables. However, this logic can be stretched to make the dual mandate include almost any
short run goal so long as it is in some way related to the economy.

[ 4 ] I would argue buying and selling securities on the short end to influence rates are a traditional Fed tool.

[ 5 ] Later they added some not so major central banks. I’m looking at you, National Bank of Denmark!

[ 6 ] Whether the Fed really can lose money is an existential question. The way government accounting works, it can if its funding cost is
greater than its revenues. But since it chooses its funding cost, can it really lose money?

[ 7 ] Wall Street Journal: “Senate Approves Roughly $2 Trillion in Coronavirus Relief,” 3/26/2020.

[ 8 ] Gains will also go back to the Treasury, eventually.

[ 9 ] Federal Reserve: “Federal Reserve announces extensive new measures to support the economy,” 3/23/2020.

[ 10 ] There were a few slight exceptions during the financial crisis, but we won’t talk about them.

[ 11 ] To the companies downgraded on March 21, the Fed might as well be saying “every rose has its thorn, fallen angel.”

[ 12 ] Reuters: “Junk bond prices rally after Fed offers lifeline to riskier credits,” 4/9/2020.

[ 13 ] For example, smaller municipalities are questioning why they are not eligible for Fed support.

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