The market is the Fed
THE US Federal Reserve (Fed) is the central bank of the world’s largest economy and it has, according to its website, five main objectives. Among these objectives are to manage the government’s monetary policy, which includes price stability and interest rates; and promoting the stability of the financial system. The latter was perhaps a result from the global financial crisis (GFC) where the Fed stepped up to rescue several “too-big-to-fail” financial institution.
The economic turmoil that came with the GFC saw central banks around the world taking up additional responsibility as they not only emerged as lender of the last resort but even buyer of the last resort, especially buying up government papers, which indirectly injected liquidity into the financial system and hence the quantitative easing (QE) programmes. Accounting wise, the Fed’s move increases the size of its assets when they buy these government bonds. On the right side of the Fed’s balance sheet, the size of its liabilities is also increased by the same quantum as it provides the liquidity to the institutions or to the sellers of these government bonds.
In essence, the Fed does not print money but simply adds zeros on its computers, so to speak. This move increases the amount of money in the financial system with the hope that the financial institutions themselves will act as conduit for economic growth as it is flushed with electronic cash. Typically the move towards QE is seen as another form of monetary policy as these measures are carried out at times when benchmark rates are at record low levels. This happened during the GFC and again today as Fed’s benchmark rate is now at the floor and the Fed, or even other major central banks, are running out of ammunition to kick-start the economy.
Since 2008, the Fed has increased its balance sheet via three distinct QE programmes resulting in the size of its balance sheet rising from just below Us$900bil to as high as US$4.5 trillion by end of 2014. Although the Fed did try to normalise its balance sheet thereafter, i.e. between October 2017 up to end of August last year to about US$3.76 trillion, a reduction of approximately Us$750bil, it did not take long for the Fed to come to the rescue of the financial market yet again.
In September last year, the US financial system experienced a squeeze in short-term money market where overnight rates skyrocketed. The Fed, realising that it could lead to severe imbalances in the market, had no choice but to intervene by providing overnight repo for the period as well as introduce a new treasury-buying programme to the tune of Us$60bil a month, starting in October 2019 and right up to the second quarter of this year. Although many economist or market strategist deemed this move by the Fed to be QE4, the Fed themselves refused to acknowledge that term for its actions.
Hence, just before Covid-19 hit the US and before the markets went into a tailspin, the Fed’s balance sheet had already expanded to reach US$4.31 trillion by midMarch of this year, an increase of Us$550bil.
As Covid-19 caused significant deterioration to the prospect of the economy as well as markets, the Fed rolled out a massive “unlimited” QE. Although the headline figures showed that the Fed will ini
tially buy some Us$700bil worth of asset purchases, that soon turn into an open-ended programme, basically suggesting that the Fed will do whatever it takes to support the market and/or economy. In fact, the Fed also initiated asset purchase programmes in the fixed-income market, and that not included its plan to purchase high-yield exchange traded funds (ETFS), but also corporate bond buying programme. This is expected to provide US$2.3 trillion to not only contain the impact of Covid-19 but to help the US economy to get back on track.
With an open cheque book, the Fed is unstoppable in expanding its balance sheet, which as at Thursday, surpassed the US$7 trillion mark to reach US$7.04 trillion. In essence, since in just 10 weeks, the Fed’ balance sheet has expanded by a massive US$2.73 trillion.
The expansion of the Fed’s balance sheet has serious implications on several counts. First, it is the equity market itself. The liquidity created seems to favour the rally on the market as can be seen on historical perspective. Chart 1 shows this correlation. Although the correlation looks broken when the market collapsed in March, the injection of liquidity by the Fed brought back the market right up again.
Chart 1 also shows that the correlation was not strong when the Fed was unwinding its balance sheet between November 2016 and August 2019, as the market was more driven by the expansion of balance sheet by other central banks, which include Bank of Japan and the European Central Bank.
Second, when the Fed decided to get its hands dirty on the fixed-income market, it also sent wrong signals to the market. First, when the Fed buys high-yield ETFS, it is essentially buying a basket of securities which represent a particular benchmark high-yield fixed-income index. There is no telling whether the companies that have issued these papers will survive the economic carnage post Covid-19 or even the new normal.
Third, the Fed’s announcement of its plan to purchase corporate debts and high yield ETFS also saw a slew of companies taking advantage of the market by issuing new papers and raised fresh funds. With the Fed providing the backstop, corporates are rushing to raise new capital as investors’ appetite for riskier asset classes, despite the challenging economic environment, is elevated knowing that the Fed is there to provide the backstop.
Up to April this year, and more so after the Fed’s US$2.3 trillion programme, debt issuance in the market just went berserk. From companies that were shunned by investors to companies that simply went to market to raise cheap capital. To-date, some US$1 trillion in debt in investment grade papers have been issued, of which some 20% were done deals just this month itself.
The Fed effectively has become almost the lender of last resort in this credit space. What is the message the Fed is giving to the market? Is there a moral hazard here as argued by many? When the Fed uses its ammunition or creates its own bazookas, there is indeed no price for risk. What happens if these companies do not survive the economic turmoil brought about by the pandemic?
What’s next? Investors now know that the Fed will do whatever it takes to support the market. Bets are now increasing that the Fed will go sub-zero in its benchmark interest rates, a notion that has been dismissed by none other than the Fed chair himself. What about the stock market? In Japan, we have seen the central bank there embarking on buying ETFS and real estate investment trusts. Will this be the Fed’s next move? Only time will tell.
In the meantime, while the Fed is busy pump priming the markets, there are other thoughts that come to mind too. For example, how would Fed unwind its balance sheet? While some of its bond or asset purchase programmes could be wound down naturally, i.e., via the maturity of the papers it is holding, but other programmes would need the Fed’s intervention and hence, similar to its asset stabilisation plan in 2017-2019, it needs to do the same. The Fed’s balance sheet could very well swell to US$10 trillion, but the real ten trillion dollar question is “what’s next?”
Some argument has been put forward that investors, whether if they are bond or equity market investors, are now complacent as the Fed is providing the backstop for all sort of papers and hence it creates a false believe that these companies are perfectly healthy when it could very well be otherwise. Some of these companies could very well be what is term as zombie companies – highly leveraged and has near-zero visibility towards profitability, but yet they are in the market issuing fresh debt papers.
To quote Dr Mohamed El-erian, the chief economic adviser at Allianz SE, the long standing market mantra of “don’t fight the Fed” has become “follow or, even better, front-run and lead the Fed”; and “The market is not the economy” is evolving to “the market is the Fed”.
The Fed effectively has become almost the lender of last resort in this credit space.