Published April 20, 2020
Today’s front page of the Wall Street Journal carries the following stories: Jobless claims top an “unprecedented” 17 million, Fed unleashes its broadest ever array of programs, Coronavirus creates a “mountain of debt”, Saudis and Russia agree to oil production cut. Those four topics encapsulate what markets have been wrestling with over the past month, and going forward. We will undoubtedly spend more time in coming weeks on most of those. This week, we are focused on the dramatically expanded role of the Federal Reserve.
The Federal Reserve, aka The Fed, is essentially the U.S. national bank. It governs the public and private banking system, sets very short-term interest rates, manages the supply of money in the economy, and acts as a “lender of last resort” for banks. In short, the Fed is the “bank for banks”, serving to provide funding (aka “liquidity”), rules and regulations, and support for the U.S. banking system.
The setting of short-term interest rates and managing the supply of money flowing in the economy has long been the Fed’s means of influencing inflation and economic growth. To that end, the Fed responded to the recent crisis through a series of emergency rate cuts, pushing short-term rates to zero.
The Fed’s approach changed during the 2008 Financial Crisis as certain credit markets stopped functioning and low interest rates were not enough to stem the damage. In November of that year, the Fed announced they would step in and buy mortgage bonds. This action stopped the bleeding in the mortgage market and ultimately put a floor under the financial market part of the crisis. As a result of taking on these mortgage bonds, the Fed’s balance sheet doubled From $1 to $2 trillion.
In the subsequent decade, the Fed never entirely backed out of active participation in the market. They bought up U.S. Treasury bonds and mortgage bonds, both in varying degrees of size. You can see in the chart below how the Fed’s balance sheet doubled again from the immediate post-financial crisis period through 2015 as they continued buying bonds. Now, the Fed’s balance sheet is projected to double yet again.
The cause of the Fed’s current step-level jump in its balance sheet comes as it announces a further expansion of its role in financial markets. Thursday, the Fed announced they would begin buying corporate bonds, including those of “fallen angels”, companies whose credit rating has recently fallen below “investment grade” status. Additionally, the Fed has set up massive lending programs to a huge swath of the U.S. economy, intending to provide “bridge loan” financial support to businesses of almost all sizes. These wide-ranging actions encouraged investors this week to buy bonds of all kinds, as the fear of rampant defaults abated.
Surveying this overall picture, the Fed has become a much more proactive and aggressive bank. By doing so, near-term defaults are averted and the economy buys some time. The federal government has already shown support for the largest and most “essential” of these businesses – Boeing, for example. For many small and mid-size businesses, the glidepath has been extended through these lending programs.
But so much is unknown. How the economy restarts and at what trajectory are a couple of the main financial questions. Clearly, some businesses will not survive the extreme hit to sales, or will not want to take on additional debt through these lending programs, no matter how generous. Other businesses will emerge with a pile of low-cost loans as a new expense item and liability to consider. From an investment perspective, the Fed’s actions have given the market some hope that the market dislocations of a couple of weeks ago are behind us. And that there will not be a sharp uptick in near-term bankruptcies and defaults. Anything beyond that is completely unknown. Oil prices remain at very low levels, certain to impair a number of drilling firms. Broad areas of the economy remain shut down with no plan to reopen, many of them small businesses with perhaps little financial cushion. It’s an unprecedented time in our history. No one can argue that the Fed is asleep on the job though.
To learn more about the Federal Reserve’s role go here:
What Do the Federal Reserve Banks Do?
The weekend news on possibly slowing coronavirus spread sent investors roaring into Monday’s session in a bullish mood. Stocks ripped higher by +7%. That good cheer carried over into Tuesday’s market open. But the initial +4% pop gave way as stocks slid into a flat finish for the day. The buying returned Wednesday on news of an OPEC-Russia meeting to cut oil production and, hopefully, stabilize oil prices at a higher level. Energy shares took flight while the S&P 500 added +3.4%. Thursday the Federal Reserve further stoked the rally by announcing a dramatic expansion of its lending facilities. The Fed backstop for credit instruments of almost all stripes sent bank stocks charging higher, helping investors look past shockingly high unemployment figures. Stocks closed the session +1.4%.
A strong week for stocks as the Federal Reserve markedly enhanced their support for financial markets. The S&P 500 responded with a +12.08% gain to return to the 2800 level. The Nasdaq 100 (QQQ) added +9.54% while small-cap stocks leaped +18.26%.
Warm wishes, stay safe, and until next week.