A Busy Few Weeks for Fed Watchers
It has been a busy few weeks for Fed watchers! Below are actions and opinions coming out of the central bank so far this month, along with our own take.
- On June 3rd, the Federal Reserve Board announced an expansion in the number and type of entities eligible to use the Municipal Liquidity Facility (MLF). All states will be able to have at least two cities or counties eligible to issue notes to the MLF regardless of population. Governors will also be able to designate two issuers in their jurisdictions whose revenues are derived from government activities, such as airports, toll facilities, and utilities.
Our Take: The MLF is designed to provide a liquidity backstop for municipalities as they face increased costs and decreased tax revenues due to the COVID-19 pandemic. Previously, eligible issuers under the MLF were limited to states, large cities with 250,000 or more people, and large counties with 500,000 or more people. The expansion is a positive for states like Maine that do not have cities or counties with such large populations. Under the expansion, Governor Mills will have the ability to designate a limited number of issuers eligible for support through the MLF.
- On June 8th, the Federal Reserve Board expanded its Main Street Lending Program to allow more small and medium-sized businesses to take part. It lowered the minimum loan amount, raised the maximum loan limit, adjusted the principal repayment schedule to two years, and extended the term to five years.
Our Take: As with the expansion of the MLF, this expansion will help to further the reach of the Fed’s liquidity efforts and provide a source of funds for a greater number of small and medium-sized companies. These are net positives for the companies taking advantage of the program and for the employees and communities indirectly impacted.
- The Federal Open Market Committee (FOMC) met on June 9-10 to discuss policy and outlook. In its ensuing statement, the FOMC cited the tremendous human and economic hardship being caused by COVID-19 in the U.S. and around the world. Weaker demand and lower oil prices have been holding down price inflation, but financial conditions have improved thanks to policy measures and the flow of credit to households and businesses. Looking forward, the committee expects the pandemic to continue weighing on economic activity, and all members voted to keep the federal funds rate at its current 0% to 0.25% target range.
In a series of speaking commitments in the days that followed, Chairman Powell and other Fed officials reiterated that the Fed will continue to use all tools at its disposal to facilitate liquidity and the proper functioning of financial markets. Consensus among FOMC members is that interest rates will remain at or near the lower bound for roughly the next two years.
Our Take: In its statements, the Fed struck a somber tone, which caused equity markets to sell off. On June 11th, the day after Chairman Powell’s press conference, the S&P 500 Index fell 5.9% and the Dow Jones fell 6.9% – the worst day for major indexes since March 16th. While markets have since reclaimed much of that loss, the swift, negative reaction underscores just how volatile markets remain. It also underscores just how much Fed policy has contributed to the stock market’s recovery, and it brings into question the market’s ability to maintain current prices should the Fed fail to keep delivering outsized stimulus.
In addition, the Fed’s commitment to ultra-low interest rates for the foreseeable future speaks to the magnitude of the current problem; a v-shaped economic recovery is not the Fed’s base case. If the Fed in fact keeps rates at the lower bound for the next two years, this decision will fall hardest on savers and fixed income investors. Such investors will have little ability to earn a reasonable rate of return by investing in safe securities like bonds and money market funds. This is likely to drive otherwise risk-averse investors into the stock market, forcing them to take greater risks than they might be able to tolerate or afford.
- On June 15th, the Federal Reserve Board announced updates to the Secondary Market Corporate Credit Facility (SMCCF), which will begin buying a broad and diversified portfolio of individual corporate bonds consistent with a diversified market index of U.S. corporate bonds.
Our Take: This news was met favorably by markets and helped to provide near-term support for stock prices. Previously, the Fed had committed to buying corporate bonds via the purchase of exchange-traded funds (ETFs) – not via the direct purchase of individual bonds. While this change should provide more liquidity and flexibility for corporate borrowers, we do have reservations about the Fed’s expanded role. Moral hazard is a concern, as the Fed will in part be deciding which companies survive. In addition, the Fed’s expanded role will only serve to further distort prices. If companies aren’t required to face consequences for bad behavior, then it becomes harder for investors to assess and price risk, both in bond and equity markets. While we understand the Fed’s desire to provide support for large corporate borrowers, we have concerns about the precedent being set and its impact longer term on corporate behavior and on asset prices.
On the whole, we view the Fed’s statements and actions since the start of the crisis as favorable. They have helped to increase liquidity and provide confidence, lifting both bond and equity markets from the lows of the COVID-19 selloff. Going forward, the Fed will continue to play a major part in the economy’s ability to recover from the pandemic-induced shutdown. That said, we would caution clients that there is ultimately only so much the Fed can do, and it has already used many of the tools in its toolbox. We therefore expect continued volatility in the months ahead.