The last month has seen unprecedented action taken by the Federal Reserve to combat the economic fallout of the novel coronavirus. With vast sections of the economy shut down for an undefined period of time and unemployment spiking to levels not seen since the Great Depression the task has fallen to the FED to float the US economy and capital markets until such a time as the virus has been contained or subsided to a tolerable level.
The FED’s response has been characterized as a bazooka and it is a very large bazooka indeed. Some of the policies revitalized Crisis era policies while some are entirely new in nature; all are louder in tenor.
A Brief Historical Account of Federal Reserve Policy
To begin, I’ll provide a quick historical review of FED policy implementation. Before the ’08-’09 Financial Crisis, the Federal Funds Rate was the primary tool available to the Federal Reserve for steering economic activity. As the severity of the Crisis was uncovered, the FED cut the target Fed Funds rate to zero. At the Zero Lower Bound (ZLB), cutting the Fed Funds Rate is no longer effective for simulating economic growth (a situation known as a Liquidity Trap) as such the FED was forced to adopt more aggressive policies (more on that below). The Fed Funds rate remained close to zero for the better part of the last decade. The FED slowly began to raise the rate beginning in 2016 and achieved a maximum target of 2.25-2.5% in 2018. As concerns about growth mounted in 2019, the FED concluded that rate hikes had been too aggressive and lowered its target to between 1.5-1.75% at the end of 2019. At the time, they signaled that this rate was intended to function as a “long run” target and it was thought that the Fed Funds rate would be range bound between 1.5-1.75% for a long time. That all changed when COVID-19 entered the scene in January/February of this year.
FED Response to COVID-19
As the virus threat came into focus and capital markets ruptured the FED was called upon to act to stabilize the economy. On March 15th, the FED announced a series of emergency rate cuts that took the policy rate from the 1.5-1.75% effectively back to the ZLB. The below graph illustrates this timeline.
However, this proved to be far too little to sooth capital and funding markets. It’s important to emphasis the importance of funding markets to the proper functioning of the economy. Banks and financial institutions often rely on short term funding obtained through interbank lending, money markets, and repurchase agreements to finance daily operations. Unrelated to corona, there was substantial concern as early as September of 2019 that funding markets were not functioning well and that there was insufficient liquidity in the system for banks to properly finance ops and maintain adequate reserve levels. Corona exasperated these concerns and many market participants feared the beginnings of a financial crisis in addition to the public health one spreading through the real economy.
It was at this point that the FED decided to dust off the old Crisis era playbook with the first step being to shore up funding markets. Beginning March 16th, the FED stepped up operations in the repo markets and announced a resumption of quantitative easing. The intuition behind both measures is fairly simple. Whereas historically, the FED has acted as the lender of last resort, lending to institutions at the discount window should they be unable to fund themselves through the interbank market, the posture now is to act as the buyer of last resort; should an institution be unable to issue a repurchase agreement (which is typically backed by T-bills as collateral) the FED will now step in as the buyer and provide the bank with the short term funding it needs in exchange for collateral.
The two charts below illustrate these operations. Neither are very intuitive to look at so let’s examine each in turn.
The first graph below illustrates the amount of overnight repo purchased each day by the FED. Specifically, in the March 15th statement the FED directed its trading desk in NY to offer to purchase at least $175 Billion in overnight repo daily and at least $45 Billion in two-week repo twice per week effective March 16th until further notice. Effectively this means that if a bank needs financing and doesn’t like the rates offered by other banks in the interbank market then that bank can approach the FED and have a guaranteed buyer/financer. From the graph, beginning the first week of March we see purchases reaching almost $100B daily and substantial activity in the subsequent weeks. This proves the system was starved for liquidity/financing at the time and FED purchases provided a necessary escape valve for banks having trouble finding a lender.
The second graph illustrates the level of repo assets held by the FED; essentially a cumulative version of the first chart. We observe that repo holdings were zero in the first half of 2019, grew initially due to in September 2019 (again, for reasons unrelated to corona) before spiking dramatically to over $400 Billion beginning in March 2020.
Facilities. Pick a Letter, Any Letter.
In addition to these commitments to in the repo market, the FED revived an alphabet soup of liquidity facilities left over from the Financial Crisis to ensure the smooth functioning of financial markets. These facilities include:
- Commercial Paper Funding Facility (CPFF): Commercial paper are short term, uncollateralized loans issued by banks, financial institutions and large corporate entities. Commercial paper can be issued with a maximum maturity of 90 days and serves as a critical short-term source of funding. CP is often rolled over month to month so it’s crucial that the market be able to absorb not only the issuance of new paper but also refinance the current outstanding paper. With this facility the FED committed to refinance high grade paper for a period of not less than 1 year.
- Primary Dealer Credit Facility (PDCF): The function of this facility is to extend a line of credit to Primary Dealers (large banks that participate in Treasury auctions) in exchange for eligible collateral. There is no strict limit to the size of a loan that a bank may take from the facility so long as they have eligible collateral to pledge. The definition of collateral was significantly expanded for this line to include investment grade corporates, international agency securities, commercial paper, municipal securities, mortgage backed securities, agency securities, plus individual equity securities. This facility will remain active for at least 6 months.
- Money Market Liquidity Facility (MMLF): This facility serves a similar function to the PDCF but is directed at money market mutual funds (MMMF). MMMF are important buyers of short-term debt securities including CP and repos. In order to ensure that the funds remain both willing to buy paper and service withdrawals the FED agreed to extend loans of unspecified size based on the same set of eligible collateral as primary dealers. This facility will remain in place for at least 6-months.
- Foreign and International Monetary Authority Repo Facility (FIMA-RF): This is a new facility created to serve the needs of international central banks who need access to US dollar-based financing. Many central banks and banks around the world hold US Treasury debt or participate in traditional US based lending markets. In order to facilitate transactions, they need to hold reserves of USD. To ensure the continued smooth functioning of these markets this facility will purchase Treasury collateralized repo from eligible foreign borrowers. This facility will remain in place for at least 6 months.
- Dollar Swap lines to International Central Banks: In order to further facilitate the smooth functioning of dollar financing markets and to ensure institutions are not constrained by the amount of Treasury debt they hold the FED opened a series of dollar-based swap lines with major central banks around the world. These swap lines enable a participating central bank to exchange their domestic currency for USD up to an eligible cap which ranges from $30-$60B for a period of 6 months. Similar to the function of the FIMA-RP, this facility is designed to ensure foreign banks have ample access to dollar-based financing.
This suite of facilities signaled very aggressive action on behalf of the FED to ensure that markets were provided with ample liquidity and to prevent a “dash to cash” which could quickly morph into a ruinous credit crunch.
Unfettered Liquidity
With basic liquidity addressed, the FED shifted its focus to other areas of the capital markets with the intent to support asset prices and encourage investment; these objectives would be achieved by calling upon the FED’s supposedly ultimate weapon…Quantitative Easing (QE).
Remember the concept of a Liquidity Trap mentioned previously? In short, a Liquidity Trap occurs when a nation’s central bank policy rate (Fed Funds rate in the US case) hits the ZLB. Theory postulates that at this point lowering the interest rate further and increasing the money supply is not effective for stimulating economic growth and can only lead to inflation. The FED first encountered this problem in late 2008 and 2009 and was subsequently forced to adopt more unconventional monetary policy tools first used by the Bank of Japan in the early 2000’s, the primary tool being quantitative easing.
We will leave the theoretical discuss of QE (how it works and what it is intended to achieve) to another post. The focus here is to understand and visualize the scope of the actions; which markets are being impacted and where to observe those impacts.
Following the Crisis and Great Recession, QE was implemented exclusively through the large-scale purchase of Treasuries and mortgage backed securities (MBS) and these instruments were where they initially turned in response to the COVID Crisis. In the March 15th statement, the FED committed to increasing its portfolio of Treasury and MBS by $500B and $200B respectively and roll over any interest and principle payments for further acquisitions. To get a sense of the size of these operations, consider the graph of total central bank assets further broken down into Treasury and MBS holdings. At the beginning of 2008, the FED held assets of about $900B on its balance sheet. The subsequent Crisis and depth of the Great Recession resulted in multiple rounds of asset purchases (QE1, QE2, Operation Twist, and QE3) that swelled the FED’s balance sheet to a (prior) peak of ~$4.5T by the end of 2014; an over 4-fold increase taking place over 5 years. By comparison, the FED executed the proposed package of $700B over the period of March 11th through March 25th; about 2 weeks!
With the speed at which assets where being swallowed up it became clear very quickly that $700B in asset purchases would simple not be enough and on March 23rd the FED embarked on what has been termed “unlimited QE”: an open-ended commitment to buy financial assets in any amount required for as long as required. Furthermore, the FED dramatically expanded the set of instruments available for purchase to include not only Treasuries and agency MBS, but also non-agency MBS, commercial mortgage backed securities (CMBS), investment grade corporates, IG corporate bond ETFs, and certain municipal securities.
To date, these operations have increased the FED’s balance sheet from ~$4.3T to over $6T in approximately 1 months’ time with no indication of slowing down any time sooner. If the speed of Treasury purchases were to continue at this pace, then the FED would corner the market in US debt in about 1 year.
Additional Info
If you’d like to learn more about the facilities or operations mentioned, please follow the below links to official statements from the Federal Reserve and Federal Reserve Bank of New York.
Press Releases from the Board of Governors of the Federal Reserve System
Press Releases from the Federal Reserve Bank of New York
Thanks for reading!
Aric Lux.
