Striking a Minor Discord? The Treasury Wants Its Money Back…

Summary

• As we expected, Secretary Mnuchin did not renew the key 13(3) facilities aimed at credit and muni market support and has asked the Fed to return the unused Treasury capital.
• This is causing a stir in the financial media and some frictions as per the Fed’s response. However, these facilities were acting more like a backstop and were barely being used.
• Unless there is economic weakness or an acute tightening of financial conditions on the back of this specific change, it should not impact future Fed policy.

Market Impact

• Credit spreads have had a tremendous run and, either due to this news or because of profit taking, are at risk of seeing some spread widening ahead. Beyond that, we need to be patient.
• The facilities going offline partially negates the money-printing fears held by some investors, which is positive dollar and negative gold and cryptocurrencies.

The Treasury Wants Its Unused Money Back

As we expected, Secretary Mnuchin announced yesterday he would not approve the extension of the Fed 13(3) corporate, main street, TALF and munis facilities (A Year-End Credit Tightening Event Ahead?, 9 November 2020). As we understand it, these were his reasons:

• The facilities have met their objectives, with corporate and muni issuance ample and spreads almost back to their pre-crisis levels.
• Facilities use has been limited: Treasury funding was meant to be levered 10 times. Instead, the Treasury committed $195bn to the four facilities, but combined lending currently amounts to $24bn (Table 1).
• These funds are usable for more immediate fiscal policy stimulus objectives.

Mnuchin asked the Fed to keep in place the other facilities that either did not have Treasury funding (primary dealers and PPP lending) or where Treasury funding came from core Exchange Stabilization Fund resources rather than from the CARES Act (MMF and CP facilities).

To be clear, the Treasury ending the facilities means that the credit already on the Fed balance sheet will remain there until it matures. In addition, the Fed would still retain Treasury commitments of $10bn each for the MMF and CP facilities as well as, we believe, $25bn for the other facilities. Furthermore, the return of the Treasury capital will have no impact on reserves: rather, it will increase/decrease the TGA and the line item, ‘Treasury contribution to equity facilities’, by an equivalent amount.

Mnuchin indicated that he wanted to reallocate the unused Treasury capital to fund new fiscal stimulus instead of having it sit idle at the Fed. To this end he has requested that the Fed returns $170bn that, together with the unused portions of the initial Fed and Treasury Cares Act appropriations would free up about $455bn for Congress to reallocate. Without Congress approval, the Treasury cannot repurpose the funds.

The Fed reacted by stating that it ‘would prefer that the full suite of emergency facilities established during the coronavirus pandemic continue to serve their important role as a backstop for our still-strained and vulnerable economy’. This reflects a more pessimistic view than the Treasury’s on the course of the economic recovery. Chair Powell believes it is too soon to assume that a vaccine will change the economic outlook. That said, the Fed is unlikely to respond specifically to Mnuchin’s decision to end the credit facilities. Rather, the Fed is more likely to require further economic weakening or tightening of financial conditions to ease further.

Should the need arise to restart these programs, the Fed would still need the Treasury’s approval. And even if a new administration was prepared to grant it, as we discussed in our prior note, we doubt the Fed would rush to turn them back on (or request them) unless there is clear bi-partisan support.

Market Implications

While the Fed purchased far fewer assets than expected when the facilities were set up, it could have purchased up to $750bn. This backstop, coupled with some targeted early credit purchases, is what helped stem the tide at the start of the Covid-19 crisis.

Given the time of year, the Treasury decisions could cut both ways.

With year-end ahead, market liquidity could be curtailed and dry up. Having these facilities go off-line right before the turn of the year could see the system command a premium to provide access to credit of any sorts. That said, after a record year of issuance, and since November and December are usually the lightest months of corporate bond market issuance (Chart 1), it should not really impact credit market dynamics.

The muni facility is the more interesting twist to the story. Although it was one of the least used facilities, time (and overall spread level movements ahead) will tell if it was providing an even bigger form of backstop to munis than we thought. Muni issuance also saw a jump this year once the Fed got fixed income functioning well again after its massive QE purchases and post these facilities.

Though not directly related to these facilities, the other area worth watching is gold, FX and cryptocurrency markets. The 13(3) facilities had the capacity to be levered to massive sizes. This, in combination with ongoing Fed QE purchases, could have taken the Fed’s balance sheet to even larger sizes than those projected at the current pace (where all else equal, the balance sheet should settle sometime next year slightly north of the $8tn mark). Some investors may have feared the Fed would take full advantage of this fast easing capacity and further dilute the dollar. But the facilities going offline partially negates this money-printing narrative.