Fed Preview: Break On Through To The NIRP Side With A Super-sized B/S?

The Federal Reserve has made one of the most dramatic displays in central bank activity in history, skipping the scheduled March meeting due to emergency meetings in between and launching a plethora of new credit easing programs in the interim. After all that, it’s hard to believe the Fed has reserved any major new policy prescriptions for the upcoming April FOMC meeting. We may see the groundwork for Yield Curve Control (YCC) – not negative interest rate policy (NIRP) – and tweaks to normal QE. However, I bet the folks at the Fed want to use this opportunity to reflect on recent policy actions and how their programs are evolving.

Rate Policy: Keeping the Doors Shut in Order to Avoid NIRP Siren Calls

For the record, I am not a fan of NIRP but there’s been much hoopla lately over the idea that the Fed is going to move rates into negative territory. That’s due to former Minneapolis Fed President Kocherlakota publishing an article on Bloomberg suggesting the Fed should do just that at the upcoming meeting. So far, the Fed has been clearly reluctant to follow the NIRP path that the ECB and BoJ have been on for a variety of reasons.

In my view, the Fed has realized that NIRP has failed to materially change the economic conditions in those regions using it (and it has come with a cost: hurting their banking systems’ ability to increase profitability, which could ironically curtail the desire to lend). Also, NIRP as a policy doesn’t have that same “shock and awe” factor seen in QE and liquidity programs, so why bother with it now? (Just expand the balance-sheet more.)

Given that it has navigated around the 13-3 (emergency lending powers) by using SPVs with Treasury capital, some believe that the Fed will also find a way to make NIRP a legitimate policy tool. I’ll leave that to the lawyers. But the Fed is keenly aware of what NIRP would do to one of the largest segments of the US financial markets, the money market fund industry. At this stage, after having started liquidity facilities to provide safe harbour for money funds, we’d find it odd if they launched NIRP in a crisis because the risk is that sidelined cash would leave those funds, causing a spike in funding rates.

The issue is that the Fed expanded its balance-sheet so fast that it has flooded the system, and that is causing rates to hit the floor. At most, we could see the Fed come up with tighter ranges (even bank tiering) for the Fed Funds target rate and try to tweak IOER to help nudge overnight rates. Lastly, I have been of the view for a while (see link) that there is greater chance of instituting Yield Curve Control (YCC) versus them starting NIRP.

Balance-sheet Policy: A Brief Pause to Reflect on the Moonshot Rise

I think most of us would agree that the recent growth of the Fed’s balance-sheet has felt much quicker, especially when viewed on a nominal basis, by comparison with what we witnessed in the 2008-9 GFC. Meanwhile there have been so many new Fed facilities to help maintain the flow of credit in the economy that we will not review them all again. But, in brief, since our last update I believe the following are the most noteworthy additions:

• FIMA (Foreign and International Monetary Authorities) Repo Facility: This program allows foreign official institutions to get cash by “repo’ing” their Treasury holdings. So far, it’s gone mostly unused; the Fed has a large network of central banks that can tap the swap lines instead.
• PPPLF (Paycheck Protection Program Liquidity Facility): To help the Small Business Administration (SBA) program, the Fed is providing liquidity to banks via term financing backed by small business loans. Fortunately, there has finally been some usage as of the latest reporting.
• MLF (Municipal Liquidity Facility): As of the last balance-sheet update there was no usage. They have also made some recent tweaks to the program. However, as per the Fed’s very own description, this facility will “purchase up to $500bn of short term notes directly from U.S. states (including DC), U.S. counties with a population of at least 500k residents, and U.S. cities with a population of at least 250k residents”.

Given all these new programs and that the Fed has been launching them intra-meeting, we expect no major surprises at this meeting – just updates.

With that housekeeping out of the way, let’s look at some pictures. In the charts ahead, I will review how fast the Fed’s balance-sheet has grown and what programs have driven most of the increase and market implications.

Chart 1: Balance-Sheet (B/S) Growth Has Been Out of This World

Source: St Louis FRED Database, Macro Hive

The one thing that most Fed watchers will agree upon is that all these charts will need constant updating in the coming weeks and months. The Fed’s balance-sheet is heading well over 30% of GDP; and it’s likely to go over 40%, given that the aim is to finance all of the fiscal stimulus that lies ahead. Meanwhile, if each one of the individual liquidity programs are fully used, that could add another 9-18% to these numbers. Overall, this means that the Fed’s balance-sheet can easily double or close to triple in size from the high water mark of around $4 trillion before the COVID-19 US outbreak.

Chart 2: In Nominal Terms, Growth Has Been More Than Double the GFC

Source: St Louis FRED Database, Macro Hive

Chart 3: SOMA Portfolio (Old Fashion USTs/MBS) Did the Heavy Lifting

Source: St Louis FRED Database, Macro Hive

Charts 2 and 3 show how massive the growth has been in dollar terms. The Fed has gone beyond doubling the growth rate of the balance-sheet expansion witnessed at the peak of the global financial crisis (GFC). Yet, what is unique now versus 2008-9 is that the majority of the growth has come from Treasury and MBS QE bond buying versus liquidity programs.

In 2008 the GFC clearly started with funding issues in the money markets, whereas in the COVID-19 market correction, the main area of focus was proper market functioning of US government debt. The ongoing record daily purchases had the added benefit of injecting reserves into the system and taking paper, which was once funded in repo, out of the marketplace. That could be why liquidity needs were met via the traditional QE route.

In my view the Fed is best served funding the Treasury during this time of uncertainty, and just allowing the government to distribute to those in need. The Fed has been slowing down its record daily purchases of USTs. It’s possible that they will return to a more standard monthly schedule. If so, they could announce that at the April meeting. They’d relay it as a sign of success and that they do not need to keep their foot so heavy on the QE gas. It’s possible that purchases will move towards $100-150bn per month, all the while the market would know the Fed could ramp up purchases quickly again if there were ever any signs of trouble in the Treasury market.

Chart 4: Fed Policy Will Eventually Impact USD Valuations Ahead

Source: St Louis FRED Database, Macro Hive

Big Picture Views

COVID-19 will permanently alter the world for a whole host of reasons. And that’s also true from a central bank standpoint and its interaction with markets, in my view. We have now seen how much the Fed is willing to intervene in order to support markets. They could always do more in size, but in terms of the financial assets that they have yet to touch, it’s is really just equities and private markets (which we don’t believe is next… well, unless it gets really bad out there). The risk is one day the Fed is unable to surpass expectations because we will already have seen it all.

That said, I’m worried about the incentives some of these Fed actions create for corporates and investors once we return closer to normality. I am a big believer that a central bank should always be the lender of last resort but at a penalty rate. The Fed could have easily kept funding various fixed income markets like corporates, structured credit and munis via short-term liquidity programs versus having these SPVs purchase of intermediate debt (by design that suggests whatever gets bought won’t roll off that quickly).

It’s also possible that markets are reading way too much into what the Fed stimulus is provding and their intent. The Fed could just be trying to cap tail risks, letting market functioning continue to allow investors to determine what is the fair value in a world that has seen growth severely impacted.

For example the credit buying programs are not up and running (perhaps we will learn more soon why) but even when they get going only if there is another seizure in the seconardy markets will the Fed’s IG and HY bond facilities get tapped (its almost like they are an insurance wrapper on liquidity risk, you only go to the Fed in a worst case scenario). Secondly we doubt corporate issuers will rely on the Fed to place paper and would rather use them as a last ditch “break-glass” moment. And the size of the ETF buying will be small verus the size of the market. Overall the Fed has found a way to support credit without firing a bullet yet. I like to characterize this a view as a “controlled burn” that firefighters use when fighting forest fires.

So far, the FX swap lines have dominated the non-SOMA balance-sheet growth as the other facilities are either being used very little or are not up and running. There is tremendous uncertainty on how the economy will look in the next 6-12 months and so there is scope for all these new facilities to get maxed out (which according to the care act would create over $4tn in total support) as the Fed may become the only game in town. For now, most of the growth has been via normal QE, which will continue in place. That alone should drive the Fed’s balance-sheet to new highs.

Market Implications

Stocks have had a nice bounce but credit is starting to roll over again. Meanwhile Treasuries have been pinned. The risk in the short-run is that, with the Fed dialing back QE, rates may rise and the Fed allows it to see where to step in later with YCC if needed. This could create a condition for another re-pricing of risk assets for the balance of 2Q20.

A super-sized balance-sheet should lead to inflation down the road, steeper curves but also a weaker dollar. We have not tilted over yet on the dollar or inflation as it will take some time, but check out Chart 4; this is for dollar-yen, but most DM currencies have a strong correlation with the relative size of the Fed to their central bank’s balance-sheet. In this example, if the Fed’s B/S vs GDP gets to 50% it could drive this ratio in Chart 4 versus the BoJ to 2.5, which would equate to 90 on the dollar-yen. Once Fed easing dominates, and all other central banks fall in line, the dollar will reprice.

George is a twenty years fixed income markets veteran. Over that time he has covered rates, structured products and credit. He worked both on the buy-side and sell-side.

(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.)