A Pause In Policy Support Could Provide A Buying Opportunity

A May pause in new policy initiatives against a backdrop of slow support to the real economy creates downside market risks. Over the longer run, though, continued improvements in COVID news, a robust Fed put, and the US electoral cycle suggest more market upside from current levels.

The SPX has retraced 60% of its February-March decline, but this speedy recovery could face tests over the next few weeks for three reasons.

(1) New policy initiatives are unlikely

The Fed has been slowing its purchases of securities and at the 28 April FOMC meeting Chair Powell stated that the policy stance was appropriate (Chart 1). On the fiscal side, Republicans are increasingly divided over the need for further large relief bills, while both Republicans and Democrats are arguing over federal support to the states. In addition, Congress is in recess for a week starting 23 May, which suggests new policy measures won’t get finalized until well into June.

Table 1: Fed Credit Facilities

(2) Channeling support to the real economy is proving difficult

Since 12 February, Fed lending to the financial sector has increased by about $280bn, including $90bn lending through three newly set up facilities (Table 1).

The risk, however, is that, despite a loosening of prudential regulation and supervision, the Fed’s stepped-up liquidity provision may not translate into increased credit availability to the real economy. Regulatory tightening in the aftermath of the financial crisis has made banks more risk averse and restrained their balance sheet expansion. Since 12 February, commercial banks’ lending has increased by $0.7tn (Table 2). However, this includes drawing from existing credit lines, estimated above $150bn, and lending under the SBA Payroll Protection Program of around $350bn. In addition, while I&C (Industrial and Commercial) loans increased by $600bn, consumer lending contracted by about $100bn.

Table 2: Commerical Banks Assets, $bn

To reach directly to the real economy, the Fed has announced the creation of six new funding facilities, but so far only one has become operational. As of 22 April, the Commercial Paper Funding Facility (open to financial as well as non-financial issuers) had lent $3bn. Standing up the other facilities could take time: on 28 April, Powell indicated that the corporate credit facilities would become operational “soon” but that the Mainstreet Lending facilities, targeted at SMEs, would take more time.

In addition, deploying the Fed facilities will require tight coordination with the Treasury. The Treasury has received $454bn from Congress in equity funding to be leveraged on the Fed balance sheet. So far, only about $215bn have been allocated, but there is no Treasury commitment to make the Fed whole if losses exceed the equity cushion. At the same time, Congress’ policies could impact the credit worthiness of the Fed borrowers: for instance, some Republicans have discussed the possibility of allowing states to default, which would affect the Fed Municipal Liquidity Facility. And the November elections could bring about an administration and Congress less willing to backstop the Fed.

Table 3: Coronavirus Relief Bills, $bn

The Fed difficulties in lending to the real economy leave the budget as the main source of support to households and businesses. Since 6 March, Congress has passed four relief bills that together represent nearly $4tn in additional expenditures and tax cuts (Table 3). However, only the Paycheck Protection Program and the individual income tax rebates, about $1.2tn, are fast disbursing. The remainder of the funding consists either of provisions that will disburse over time such as extended unemployment insurance and sick leave, food assistance, health care and tax cuts, or of funding of various levels of government.

(3) Against this backdrop, the real economy liquidity crunch could tighten over the next couple of weeks

Some recurrent household expenditures, such as rent, tend to be paid at the beginning of the month. At the same time, unemployment is now significantly higher than a month ago: since 21 March, about 20m newly unemployed have filed for benefits. As a result, rent payments and, more broadly, payments of recurrent expenditures could turn out more difficult this time around. For instance, tenants across America are organizing for May rent strikes.

There is a chance, therefore, that the news flow on the solvency of households and small businesses could turn negative over the next few weeks. With many investors questioning the gap between market and economic recovery, this could lead to a sell off.

Upside Potential

Nevertheless, over the longer run I see more market upside from the current level for three reasons.

1. The data continues to show that the spread and severity of the epidemic are slowing.
2. The Fed put would likely kick in if there was a marked selloff as the Fed sees its policy transmitted through financial conditions and unemployment is likely to cross 10% this month.
3. With presidential elections scheduled in November, policymakers will do whatever it takes to ensure a strong recovery is underway before then. A May selloff would therefore be a buying opportunity.