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The Fed’s Big Bazooka

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POW!#*@  BAM&$# SMASH!@#$% KABOOM*#!@?%  That’s the sound of the Fed’s big bazooka, the use of which was announced on Thursday, April 9;  $2.3 trillion worth of lending to almost every segment of the U.S. credit markets. In the announcement, Chairman Powell signaled that the Fed was prepared to expand their balance sheet indefinitely (i.e. no limits) to stem any long-lasting damage to the U.S. economy. This far surpasses any of their actions taken during the financial crisis or its aftermath. And, every financial market in the world rallied. This backstops nearly every aspect of the credit markets, including some aspects of high yield! (Money, apparently, really does grow on trees!!)

Some Recent History

Because of the actions of governments around the world to stem the spread of the coronavirus pandemic, an economic and liquidity crisis ensued. Markets feared that many private sector companies, which had borrowed liberally for the past 10 years, would suffer record defaults and bankruptcies. 

The Fed had acted twice since mid-March, once to reduce rates to 0%, and the second time to provide liquidity to the overnight markets. Prior to this announcement, and due to these recent actions, the Fed’s balance sheet had already ballooned to more than $6 trillion, from $4.2 trillion in February ($4.5 trillion was the prior peak as a result of the Great Recession). Expectations are that the balance sheet could reach twice its current levels. 

Details of the Operation

This move provides funding for the entire economy and is aimed at removing the risk of a broad-based private sector collapse for lack of liquidity.1 Here is a summary of what the Fed intends to do:

  • $500 billion of loans to municipalities (with a $35 billion Treasury loan guarantee; i.e. the Treasury eats the first $35 billion of loan losses); this backstops the muni bond market, as investors were worried that a shut-down economy would not generate enough tax revenues for the entities to meet their obligations;
  • Loans to mid-sized businesses (<10,000 employees and less than $2.5 billion in 2019 revenues). Principle and interest will be deferred for one year with interest rates between 2.5% and 4.0%;
  • Support for banks lending to small businesses under the PPP provisions of the CARES legislation. They even lifted some growth sanctions on Wells Fargo to allow them to participate, as most banks are overwhelmed with credit applications and have chosen to first service their existing customers. Without the easing of sanctions, Wells’ clients would have been out of luck!
  • An $850 billion expansion of the three existing short-term lending facilities established earlier in March to insure credit availability to households and businesses; under this expansion, the Fed expanded the types and levels of acceptable collateral for participating banks;
  • For the first time ever, the Fed will:

  1. Purchase private sector corporate investment grade bonds;
  2. Purchase private sector high yield bonds as long as their investment rating was investment grade on March 15. Such bonds are known as “fallen angels.” Moody’s and S&P have been quite busy downgrading over-leveraged companies from investment grade to junk at a record rate ($560 billion in March’s second half). The result is that the only credit sector that isn’t backstopped is the deep junk bond market. (It is my view that the Fed will eventually backstop that sector too.)

A Real Announcement Effect

The Fed has yet to actually implement any of these programs, but their announcement brought droves of private sector money from the sidelines on Thursday, April 9, which was a giant step toward resolving the liquidity issues that began surfacing as early as last September (remember the run-up in yields in the repo market just prior to the Fed’s September meeting set?). The announcement alone had a huge impact on corporate bond prices.  Because Thursday’s rally was just the announcement effect, we can expect that bond prices will rise further as the Fed actually operates in those markets.

The List

Through these new programs, the Fed will now be supporting just about any credit segment you can think of including consumer loans (auto, credit card, student loans), small business loans (via the SBA and the CARES legislation), commercial operating, equipment and real estate loans, municipal bonds, investment grade bonds, and the recent fallen angel high yield segment. I can’t think of any sector that has been forgotten.

Other Economic Considerations

Jobless Claims: The Fed’s announcement, while certainly the most important recent economic event, wasn’t the only noteworthy one. The latest data show continuing record jobless claims, now 16.8 million in the three weeks ended April 4th. The next BLS unemployment survey period will include layoffs that have yet to be reported in the weekly surveys, likely to be several million more. With just the 16.8 million layoffs reported so far, the U3 rate would be in the 15% neighborhood. Thus, somewhere near 20% is a possibility. While we know this intellectually, when the number is reported, it will still be shocking.

Oil Issues: The Saudi’s and Russia finally put their differences aside and agreed that OPEC should cut oil production by 10 million bbl./day (mbd), even as some meeting participants objected. This doesn’t appear to be enough to materially impact oil prices in the short-run (i.e., stop them from falling or remaining at depressed levels), as oil demand, world-wide appears to have fallen, by some estimates, as much as 35 mbd. It used to be that lower oil prices benefitted the American economy, but that changed over the last few years with the ramp up of fracking, as the U.S. is now the largest world producer, but also the highest cost producer. So, today’s existing low oil prices have a large negative impact on this sector. In addition, the economic shut-down has caused a significant reduction in miles driven, as evidenced by the rebates given to consumers by all of the major auto insurers. Thus, the positive impact to U.S. consumers has been muted.

Re-opening Economies: Last week, President Trump began publicly noodling on how to re-start the U.S. economy, a positive sign. Then, at week’s end, the Czech Republic, Austria and Denmark announced a partial re-opening of their economies after Easter. The Czech Republic will allow their citizens to participate in tennis and swimming and will allow sporting good shops to re-open. Austria, too, will allow business to resume at small shops. But the economy to watch will be that of Denmark, which will allow schools to re-open. If the number of cases there remains stable (3,781 active cases as of April 11), even with children back in school, it may serve as a model for the rest of the world to follow.

The Equity Rally

Naturally, the equity markets rallied on the Fed’s announcement, probably relief that not everything is going to collapse all at once. But let’s not get too excited. Stock buy-backs are now pretty much a thing of the past, and the past 10 years of financial engineering are not likely to be repeated anytime soon. That will impact PE ratios. Corporate operating profits have been flat for five years and are now likely to struggle for at least a few quarters. So, how high can stock indexes rise?

Everyone, of course, would like to redeploy any excess cash when the equity market bottoms. With so much still unknown, and the uncertainties of the current economic shut-down (and with the latest data on initial unemployment claims remaining at extreme levels), calling the bottom of the equity market is impossible. But, don’t fret! Economist David Rosenberg’s research revealed:

  • If you picked every bottom of every bear market since 1960, your average annual overall return would have been 17%;
  • If you reinvested in the reflexive rebounds in those bear markets (i.e., in the up markets but before the bottom occurred), your average annual overall return would have been 7%;
  • If you waited for one year to invest after the real market bottom had occurred, your average return would have been 14%, not a lot of sacrifice to acquire a modicum of certainty.

Stay safe and invest wisely!

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