Credit | Monetary Policy & Inflation | US
As part of the COVID-19 response, the Fed established a series of lending facilities under Section 13(3) of the Federal Reserve Act. This authorizes the Fed to lend to non-bank borrowers ‘in unusual and exigent circumstances’. Five of these facilities (muni, corporate, main street, CP and TALF) are in active use (Chart 1). Over the past 12 weeks, the main street facility has grown by about $400mn a week, TALF by $200mn, corporates by $100mn and the muni facility by $40mn.
The facilities’ direct impact on the Fed balance sheet size has been overall limited. Yet they have strongly impacted markets through both the announcement effect and initial usage. Spreads tightened quickly after the implementation of these facilities.
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Summary
- Key GOP policymakers have stated that Fed lending facilities should not be extended at end-year.
- The incoming Treasury secretary could reverse such a decision. Meanwhile the Fed can decide to expand its 13(3) lending facilities usage marginally, especially if bipartisan consensus is absent.
- This would remove a backstop that has supported corporate bond and muni issuance since March.
- Alternatively, Treasury secretary Mnuchin could decide to extend some facilities if stimulus talks fail.
Market Implications
- Medium term – Credit spreads risk widening if the 13(3) facilities are allowed to sunset at year-end.
Big Picture: Reviewing the Fed’s 13(3) Facilities (They’re Barely Growing Now)
As part of the COVID-19 response, the Fed established a series of lending facilities under Section 13(3) of the Federal Reserve Act. This authorizes the Fed to lend to non-bank borrowers ‘in unusual and exigent circumstances’. Five of these facilities (muni, corporate, main street, CP and TALF) are in active use (Chart 1). Over the past 12 weeks, the main street facility has grown by about $400mn a week, TALF by $200mn, corporates by $100mn and the muni facility by $40mn.
The facilities’ direct impact on the Fed balance sheet size has been overall limited. Yet they have strongly impacted markets through both the announcement effect and initial usage. Spreads tightened quickly after the implementation of these facilities.
Extension of 13(3) Facilities May Have to Wait for Incoming Cabinet
The 13(3) facilities, except for the CP facility, expire at the end of December. At the November presser, Chair Powell refrained from definitively indicating that the Fed would continue these facilities beyond year-end. But he mentioned that the FRB is ‘just now turning’ to the question of extending them.
Under the Federal Reserve Act, extending these facilities requires prior approval of the Treasury secretary. In addition, the funding of the facilities comes partly from the CARES Act that appropriated $454bn in equity for this purpose, which can be leveraged up to 10 times. So far the Treasury has provided only $114 bn in equity, and, as mentioned above, the Fed lent only $125bn. As set out in the CARES Act, these facilities were to expire on 30 September. However, in a July press release they extended them through year-end (all within the scope of the original CARES Act language as well).
For now, therefore, the power to extend the facilities rests with the Treasury secretary. In a letter dated 16 October 2020, Secretary Mnuchin indicated that he had no plans to extend the muni facility in view of the municipal bond market significant recovery. And, recall that that the muni facility has been barely used since its launch. Furthermore, GOP Senator Toomey, a prominent member of the Senate Banking Committee, stressed that the muni facility was not designed to be a substitute for direct fiscal aid.
Toomey further believes that all the 13(3) facilities should also conclude at end-year because they have been ‘wildly successful’. He thinks that keeping the facilities open risks their use as quasi-fiscal policy instruments and could create ‘a dangerous precedent for future business cycles’.
Fed May Get Cold Feet Without Bipartisan Support
Without a stimulus deal before year-end, there is a risk Mnuchin does not extend the 13(3) facilities. Absent a deal, his concern could be that the facilities would become a back-door substitute for federal budget subsidies to local governments and businesses. In such an instance, the Fed would be unable to extend new credit via these facilities but simultaneously would not have to refund the equity injections for the facilities or liquidate their holdings. It could allow them to mature on its balance sheet.
At this stage, a major stimulus deal before end-year appears unlikely. President Trump, with the support of prominent Republicans, seems intent on waging an extended legal war to contest the election outcome. In our view, an agreement on the election results is a pre-requisite for a big stimulus deal (The US Presidential Elections: The Possible Outcomes and Their Market Implications, 29 October 2020).
Furthermore, so long as the credit and muni markets avoid acute stress, Powell could likewise avoid officially declining any overture from the incoming Treasury secretary injunction to restart the 13(3) facilities. Instead it could simply go slow with any additional credit extensions. As mentioned above, there has been no new credit under the muni facility since August. In other words, after it became clear that no new stimulus deal with funding for states and local governments would be readily forthcoming. Overall, markets will react negatively without a fiscal stimulus deal before year end, and made worse if the Fed’s 13(3) facilities go offline at the same time.
George is a twenty years fixed income veteran. Over that time he has been an active participant on the research and investment side covering rates, structured products and credit. He worked both on the buy-side and sell-side. He can be reached here.
Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)