Macro Wrap-Up

We Interrupt Your Regularly Scheduled Fed Programming

Topics - Macroeconomics

${ numberSection } ${ text }
We Interrupt Your Regularly Scheduled Fed Programming

If you’ve found the Fed’s recent actions confusing, you are not alone. The sheer volume of what has been done, the complexity of the programs, and the Fed’s choice of names has made them almost impossible to follow. Not only has the Fed boldly tested the limits of its mandate, but it has also tested the limits of the English alphabet. MMLF, SMCCF, PMCCF. These acronyms seem designed to be forgotten. 1 1 Close Still I prefer awkward acronyms to the not so subtle titles like the CARES Act.   Perhaps the Fed is telling us that it is taking the crisis so seriously that its program-naming department has been repurposed to help in the effort.

In a normal economic environment, the Fed doesn’t need to create any of these fancy programs. For most of the past thirty years, the Fed has used a simple tool to achieve two broad economic goals. It has tried to influence inflation and employment by adjusting the rate at which banks lend to each other overnight. However, the extreme slowdown in economic activity makes it impossible to achieve anything resembling maximum employment or stable prices in the near term. The Fed has been forced to change both its goals and its tools. 

A shift in strategy is by no means unprecedented. For example, during and after World War II, the government tasked the Fed with maintaining low interest rates on the war debt. 2 2 Close It’s difficult even to articulate what the Fed’s goals were prior to World War II.     There have been several times in which the Fed has shifted from its mandate to focusing on ensuring financial stability. 3 3 Close It is possible to argue that financial stability is just a way to achieve stable inflation and maximum employment. After all, a financial crisis would meaningfully affect these economic variables. However, this logic can be stretched to make the dual mandate include almost any short run goal so long as it is in some way related to the economy.   Right now, the Fed is acting as a crisis manager. While it can’t do anything about the health crisis, it is trying to prevent the enormous drop in activity from becoming a financial and economic crisis.  

Members of the Fed think it needs to do two things to achieve these goals. First, it needs to ensure that markets can function properly. Second, it needs to ensure that the economy can function at all. While these sound painfully obvious, they are profoundly difficult to achieve. The shutdowns have displaced enormous numbers of workers and businesses. If too many businesses are shuttered, the economy can’t return to past levels even in a best-case scenario in which the health crisis ends quickly. The Fed can’t bring the economy back into equilibrium so long as activity is stopped, but its members think it can create the conditions for it to return in the future.

In the absence of a single perfect tool, the Fed has instead enacted a series of increasingly aggressive measures. It started with conventional measures such as cutting its target rate to zero and adding to its repo facilities. 4 4 Close I would argue buying and selling securities on the short end to influence rates are a traditional Fed tool.   It eased enforcement of some regulations. That wasn’t enough to stabilize markets so the Fed announced it would buy 700b of Treasury Bonds and Agency MBS. While QE may have seemed unorthodox twelve years ago, it has now become a very common tool for central banks around the world. But sadly, its acceptance has not made it effective. Even the safest of markets, U.S. Treasuries, remained dysfunctional. The Fed then revived swap lines with other major central banks and made the QE unlimited in size. 5 5 Close Later they added some not so major central banks. I’m looking at you, National Bank of Denmark!   These measures were enough to bring back some stability in government bonds and foreign exchange markets, but other markets remained far from normal.

As the crisis worsened, investors avoided credit risk in almost any form. Corporate and municipal lending was essentially frozen. The Fed was aware that no amount of purchases of government bonds could fix that, but it faced legal and regulatory obstacles to additional action. The Fed is restricted from taking credit risk to prevent it from picking winners and losers in the economy. And perhaps to stop it from losing money. 6 6 Close Whether the Fed really can lose money is an existential question. The way government accounting works, it can if its funding cost is greater than its revenues. But since it chooses its funding cost, can it really lose money? To get around this, the Fed created facilities to support these markets with the help of the Treasury department. The Treasury provided equity for these facilities from its stimulus package budget. 7 7 Close Wall Street Journal: “Senate Approves Roughly $2 Trillion in Coronavirus Relief,” 3/26/2020.   These facilities can buy assets with up to 10x leverage provided by the Fed. Any credit losses will come out of the capital the Treasury put in. 8 8 Close Gains will also go back to the Treasury, eventually.  

These facilities started with corporate bonds, but later added municipal bonds and packaged loans. 9 9 Close Federal Reserve: “Federal Reserve announces extensive new measures to support the economy,” 3/23/2020.   But the Fed felt even this was not enough; it had at least one surprise left. Previously, in joint programs with the Treasury, the Fed was careful to buy only investment grade assets. 10 10 Close There were a few slight exceptions during the financial crisis, but we won’t talk about them. Earlier this month, the Fed abandoned that restriction. Its facilities can now directly buy high yield bonds so long as they were investment grade back on March 22, which happens to be the date when they started the programs. 11 11 Close To the companies downgraded on March 21, the Fed might as well be saying “every rose has its thorn, fallen angel.”   The facilities can also buy high yield ETFs which can hold a variety of sub-investment grade issues. 12 12 Close Reuters: “Junk bond prices rally after Fed offers lifeline to riskier credits,” 4/9/2020.     

This may seem like a natural progression, but it is actually a very bold step for a central bank which until last month avoided buying credit instruments. It goes beyond just stabilizing specific markets. The Fed is trying to tell investors and business that it is not afraid to use any tool it can think of to stabilize markets, and that it will continue for as long as it feels it needs to. One of the criticisms of other central banks facing severe deflationary pressure was that they were too timid to use their unlimited firepower. The Fed members may be channeling Miley Cyrus by telling us that they can’t stop. They won’t stop. Based on recent moves in these markets, it seems that the sellers may have finally gotten tired of listening to it. 

During the last financial crisis, a number of folks criticized the Fed for overstepping. Perhaps the most stinging of the critiques was that the Fed was making the financial system riskier by creating moral hazard. The core of this argument is that if the Fed helps banks and other failing businesses to survive, these entities are encouraged to act even more irresponsibly because of the implied safety net. These same critiques are being made now, but they don’t seem as prevalent. Perhaps because this has been a global health crisis, people view the economic problems as the result of bad luck rather than the bad behavior of companies. The Fed seems to be taking as much criticism for being too narrow in its support as it is for overstepping. 13 13 Close For example, smaller municipalities are questioning why they are not eligible for Fed support.   Still, the Fed’s actions are far more potent this time. It isn’t quite throwing money out of helicopters, but it’s the closest the Fed has come in recent memory. Purchases of corporate bonds are very different from purchases of Treasuries. They reduce the amount of available risky assets and make credit cheaper in public markets. This credit easing can move markets significantly and affect the economy. The initial effects are usually positive for asset prices. Longer-term, it could create bubbles or inflation. Right now, that probably won’t affect pricing, because markets can’t seem to look further than the end of the crisis.

What We Are Watching
Manufacturing and Services PMIs in the U.S., Eurozone, and U.K. (Thursday)

This week, Markit will publish its preliminary April PMI results for the U.S., the Eurozone, and the U.K. PMIs are calculated based on the net proportion of survey respondents seeing growth vs. contraction in dimensions of their business such as production, employment, and new orders. While different countries implemented lockdowns at different times, nearly all large countries had imposed significant restrictions on public gatherings and various types of business operations by the end of March. As a result, PMIs based on in early April will likely show the broadest weakness in manufacturing and service sector activity of the current downturn. If coronavirus containment efforts continue to show progress and restrictions begin to loosen in some places, the April readings may mark the low point for the PMIs, after which the pace of stabilization and recovery will become the key focus for market participants. 

 U.S. Initial Jobless Claims (Thursday)
Approximately 22 million workers have filed initial jobless claims in the U.S. in the past four weeks. The sudden stop of the economy following lockdowns in most states to contain the spread of COVID-19 has produced the steepest increase in jobless claims in data going back over 50 years. The data paints a bleak picture of the labor market in the near term, but the persistence of the downturn remains uncertain. Weekly jobless filings have decelerated in the past two weeks, but continue to be orders of magnitude larger than the pre-lockdown levels of early March. Jobless claims are highly reliable high-frequency data on the state of the labor market, as such, market participants will continue to monitor the weekly changes to assess the degree of stabilization in employment in the weeks ahead. 

U.S. UMich Consumer Sentiment (Friday)
Unsurprisingly, consumer sentiment has taken a big hit in recent weeks. The Consumer Sentiment Index produced by the University of Michigan experienced its largest monthly decline since 2005 in preliminary data for April. Next week, the market will get another update on consumer sentiment as U. of Michigan will release final numbers for the month. Broad-based declines in retail sales data released this week as well as record-breaking increases in jobless claims bode poorly for these consumer sentiment figures.

This material has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision.


Past performance is not a guarantee of future performance.


This document is not research and should not be treated as research. This document does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR.


The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the author or AQR will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only.


The information in this document may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.