Don't fight the Fed

Members of the Federal Open Market Committee were remarkably blasé about the coronavirus risks at the end of February. James Bullard, President of the St Louis Federal Reserve, argued back then that rate cuts were “a possibility if a global pandemic actually develops with health effects approaching the scale of ordinary influenza, but this is not the baseline case at this time”.

Those comments have been badly overtaken by events. Over the course of two emergency meetings in the past couple of weeks, the Federal Reserve (Fed) has been compelled to cut interest rates by 150 basis points and restart its quantitative easing programme. We have seen similar, albeit less dramatic, policy U-turns around the world.

What’s truly remarkable is the breadth and depth of interventions that have been necessary to stabilise financial markets. We have seen repo operations (securities lending from the Fed); we have seen new facilities to support money markets and the corporate bond market. We are still awaiting details on the “Main Street Lending Facility” that will support bank lending.

However, even the “conventionally unconventional” policy of buying government bonds has been remarkable in its scope. On 12 March, the Fed noted “highly unusual disruptions in Treasury financing markets” that required fixing. The cracks appearing in the US Treasury market included:

     - huge day-to-day volatility in government bond yields

     - a collapse in liquidity across the curve (but most pronounced at long maturities)

     - a collapse in the price of the “inflation compensation” embedded in Treasury Inflation Protected Securities (TIPS)

     - the soaring interest rate on government debt relative to interest-rate swaps of the same maturity

Noting those problems, the Fed launched a truly massive intervention. From 12 March through to 3 April, the Fed will have purchased $1 trillion of US Treasury securities. In the aftermath of the financial crisis, the pace of such buying peaked at $870 billion per annum in the 12 months to August 2011.

That is worth repeating: the Fed has now bought more Treasuries in the space of three weeks than it did in the worst 12 months following the financial crisis.

Let’s put some of those numbers into context:

1. At the end of February, the Fed held just over $2 trillion of US Treasury notes, bonds and TIPS. This has increased by 50% in the space of two weeks.

2. At the end of February, the total value of notes, bonds and TIPS issued by the US government came to $14 trillion. The Fed already held $2 trillion (see above). In very short order, it has just bought 8% of the remaining stock.

3. The fiscal stimulus recently passed by Congress will plausibly lead to $2 trillion of additional issuance over the next 12 months. The Fed has bought up half of that amount already.

What’s the takeaway message from all this?

Economists and market strategists like to talk about the Federal Reserve’s “dual mandate”, but that reflects a poor understanding of its role. The Federal Reserve Act explicitly defines its role:

All three parts of that mandate are now live.

There is an infamous old investment dictum: “Don’t fight the Fed”. We are sceptical about whether the Fed’s efforts can meaningfully alter the path of defaults and earnings downgrades that are an almost inevitable by-product of COVID-19. But, in troubled times, we shouldn’t have any doubt about the Fed’s ability and willingness to fix the cracks in the Treasury market.