Whatever it takes 'Cause I love the adrenaline in my veins I do whatever it takes - Imagine Dragons, Whatever it takes
Did Jerome Powell use a line from an Imagine Dragons song to guide him in the Federal Reserve’s response to the global COVID-19 pandemic? Let’s hope not. In fact, despite promising to do “whatever it takes” to save the economy, it is not even certain if Jerome Powell knows who the Imagine Dragons are.
That said, he has reiterated this line since the Federal Reserve (Fed) began a series of actions and operations in early March when the COVID-19 pandemic started to significantly impact global economies and financial markets. In doing so, the Fed focused on two primary objectives: lower interest rates to support economic activity and provide liquidity to prevent disruption in financial markets. Some actions focus on a singular objective whereas others attempt to address both.
On March 3, the Fed announced a cut of its overnight lending rate by a half a percentage point (from 1.5% to 1.0%). This rate influences the overnight rate that financial institutions lend to and borrow from each other, which is known as the Fed Funds rate. Therefore, as the central bank lowers its overnight rate, the equivalent market overnight rate or, the Fed Funds rate follows along.
Overnight rates also influence expectations around short-term rates such as 3-month rate, 6-month rates, and even longer terms. Typically, the longer the overnight rate is expected to remain in a certain range, the more it will pull shorter-term rates to that range.
On March 15, the Fed cut the rate a full percentage point, which effectively brought the Fed Funds rate close to zero. Based on both the current overnight rate and the expectation of where this rate will be in the foreseeable future, market interest rates for all maturities have all dropped to historic lows. In fact, for all terms less than two years, yields on Treasuries dropped to below 0.25%.
These measures are designed to keep down the cost of loans for the banks and, ultimately, their customers in order to allow access to a low cost of borrowing.
While adjusting the Fed Funds rate has been a common tool of the Fed, it has had mixed results in the past in trying to help stimulate economic activity. In that regard, for many borrowers of all sizes, this action may simply help them survive the current crisis rather than foster near-term economic expansion.
Another measure that the Fed has taken during the current crisis is Quantitative Easing (QE). The Fed implemented this strategy during the financial crisis of 2008 and has redeployed it today – just at an extraordinarily faster rate (see graph). Using its exclusive ability to print money, they can make large scale purchases of bonds – primarily US Treasuries and government agency debt. Purchases by the Fed push up the prices for these securities which in turn lowers their yields. Yields on Treasuries and Agency debt serve as benchmarks for a wide variety of borrowers including, corporate, state and municipal, and homeowners.
While not explicitly targeting liquidity, QE also results in more cash being injected into the balance sheets of financial institutions.
QE and the Fed funds rate are not the only tools in the Fed’s arsenal. The central bank has also been very active in repo markets. The repo market is how short-term fixed income trading activity at the institutional level is financed. In a simple sense, repos are short-terms loans from the Fed into a developed market of institutional lenders and buyers who, in effect, pledge their holdings of US Treasuries in return for cash. Without an efficient repo market, short-term borrowing rates jump and liquidity in this critical section of the global marketplace dries up as the source of cheap and reliable financing disappears. The Fed has been intervening in the repo markets since last fall when a cash run led to a jump in short term borrowing rates. The Fed had planned on scaling back support for this funding market by year end 2019 but pivoted to offering almost limited unlimited support during the crisis. In addition, the Fed has also allowed for foreign central banks to access its repo capabilities. This allows then to exchange their holdings of Treasuries for overnight dollar loans.
In addition to the more traditional tools just outlined, the Fed is also providing liquidity to the market with its purchase of asset backed securities, commercial paper and corporate debt. Attention to these markets has helped assure investors that the Federal Reserve, as well as the other U.S and foreign agencies and regulators, are doing what is available to them to prevent a market collapse and help ensure liquidity and availability of funding, especially to corporations, and thus employers. Coordinated efforts by all these stakeholders is critical to the stability of the global economy as well as the asset markets.
As the lender of last resort, the Fed is also offering out its “discount window” to banks at a lowered rate of 0.25%. During April of this year, banks borrowed more than $60 billion through this facility, the most since 2009. Borrowing at the discount window has long carried a stigma because of speculation about which banks were using it and if they were doing so in a very weakened condition. The Fed changed its disclosure practices about which institutions were using the discount window in order to dampen speculation and runs on specific banks who use it. As a sign of its newfound acceptance – at least temporarily – JPMorgan Chase announced in mid-March it would execute public discount window transactions.
Indirect impacts of liquidity and lower interest rates
When yields on many fixed income securities drop in response to lower interest yields brought on by Fed policy, investors may seek to reallocate assets away from bonds. A direct beneficiary has been the stock market. Combined with intense optimism about a restart of the economy, the S&P 500 rose 37% off its March lows and, at its recent peak, was only 15% below its all-time high. As many other factors contribute to stock prices and valuation, even if the Fed promises “to do whatever it takes” to save the economy, investors should be mindful of the perils of buying into equities simply because they represent the next best alternative to lower yielding assets. If the adrenaline and optimism fade and dismal corporate earnings become more relevant factors in determining stock prices, the market could be repeating the bounce it had during the last global financial crisis – a bounce that was followed by a retreat to its lows six months after the crisis began.
– Published by Lance Eckel and Matt Porio, Finance IQ
Matthew Porio, CFA, CTP
Matt is a Managing Partner of Finance IQ and heads up our advisory business. He has combined over 30 years of international capital markets experience with 10 years of corporate training and advisory engagements to become a lead facilitator in a number of financial topic areas. He started his Wall Street career with Salomon Brothers in the mortgage-backed securities group and shortly thereafter became a Vice President of Global Markets at Chase Manhattan Bank. In 1996, he became the Chief Dealer at American Express Bank and in 2001 was promoted to Global Head of Markets. Matt was also Executive Vice President and Co-Head of Global Markets in the U.S. operations for the Bank of Ireland. Following his career on Wall Street, Matt founded Lucas & Associates, a consulting and risk advisory firm that created financial and risk management solutions for over 50 corporations across a variety of industries in the U.S. and overseas.
Matt holds a BA (cum laude) in Economics from Duke University and an MBA in Finance from the Fuqua School of Business; he also holds an MLIS from St. John’s University where he was a Laura Bush scholar. Matt is a Chartered Financial Analyst (CFA), a Certified Treasury Professional (CTP) and holds an ACI Diploma.