Fed Deploys Its Full Arsenal, but It Still Has Some Tools
Investors are looking for the central bank to help unclog markets for short-term corporate deb
The Federal Reserve on Sunday unleashed its arsenal to prevent market strains from turning a public-health emergency into a financial crisis, but investors are pushing for the central bank to pull more levers to cushion the economy against a severe downturn.
The Fed slashed its benchmark interest rate to near zero and said it would buy $500 billion in Treasury securities and $200 billion in mortgage bonds over the coming months to address unusual strains in those markets that surfaced last week as the novel coronavirus spread world-wide.
Many analysts say more Fed help may be needed to alleviate market pain amid signs that banks are reluctant to use their balance sheets to unclog other credit markets. Investors on Monday focused their attention on two tools the central bank deployed during the 2008 crisis that they said could help.
The first is the Term Auction Facility, which the central bank used between 2007 and 2009 to provide short-term loans to banks without the stigma of borrowing directly from the Fed’s emergency-loan discount window, which banks tend to avoid because it can signal distress.
So far, the Fed and other banking regulators have focused on persuading banks to use the discount window. The Fed extended terms and slashed the rate on discount-window loans to 0.25% from 1.75%, lower than the rate set during and after the 2008 crisis.
The second would be a tool to help unclog the market for short-term commercial debt, which has been strained as money-market mutual funds and other investors seek to sell such commercial paper at the same time demand for such short-term cash is rising from companies that face unanticipated funding pressures due to the virus.
“The Fed’s actions on Sunday did not address the [commercial-paper] market and mounting credit concerns,” Mark Cabana, head of short-term interest-rate strategy at Bank of America Securities, said in a report Monday.
The pandemic has delivered a blow to corporate credit markets by raising concerns that borrowers will be less creditworthy as they face falling revenues. Clogged commercial-paper markets could lead firms to instead draw on bank lines of credit, which could raise funding needs for banks.
Investors are urging the Fed to relaunch a facility along the lines of its 2008 Commercial Paper Funding Facility, when money-market mutual funds and other investors, facing a cash crunch, became reluctant to purchase short-term commercial debt. Under the program, the New York Fed provided three-month loans to an entity that purchased commercial paper directly from eligible issuers.
To create the facility, the Fed had to invoke special powers that allow the central bank, citing “unusual and exigent circumstances,” to authorize its reserve banks to extend credit. In 2010, Congress required the Fed to seek approval from the Treasury before using its so-called 13(3) powers, named for the section of its charter that allows it to stand up such last-resort programs. As a result, the Treasury would have to sign off on any new facility.
Fed Chairman Jerome Powell didn’t rule out using those tools down the road. “We have nothing to announce on 13(3) powers, but of course that’s part of our playbook in any situation like this,” he said Sunday.
White House economic adviser Lawrence Kudlow hinted at coming action on Monday. “The Fed has enormous power,” he told reporters at the White House. “And it looks like they’re going to start using it in connection with the Treasury Department and the president and the executive branch.”
The Fed has focused its efforts so far on restoring liquidity to the Treasury and mortgage-bond markets. On Thursday, the Fed launched an aggressive campaign to reduce strains there by providing nearly unlimited sums of short-term loans to 24 large financial institutions, known as primary dealers, that function as the Fed’s exclusive counterparties when trading in financial markets.
Banks were slow to take up the Fed on those loans last Thursday and Friday, which prompted the Fed to switch course to buy Treasury securities on the open market. “What we learned was that we needed to go direct here rather than trying to intermediate through the dealers,” Mr. Powell said Sunday.
Market functioning hadn’t improved much by the time markets closed Friday, setting the stage for Sunday’s action. While officials could have waited until their regularly scheduled meeting this Tuesday and Wednesday to cut rates, they didn’t believe they could wait any longer to address strains in bond markets.
But the market for repurchase agreements, or repos, still showed signs of stress Monday.
Often called the grease that allows the Treasury market to trade, repo markets have been under duress over the past two weeks. Many of the Fed tools were intended to stabilize this crucial piece of financial plumbing, but the repo rate is still more than a percentage point above the Fed’s target.
“You are seeing the strains in the commercial-paper dislocations already showing up” in other markets, such as the one for repos, said Priya Misra, head of interest-rate strategy at TD Securities.
Traders say the problem is structural: Notably, the Fed is relying on banks to act as intermediaries through which they can funnel cash to those who need it, including businesses and hedge funds. But rules drafted in the wake of the 2008 financial crisis have increased the cost of capital and limited the amount of balance sheet banks can deploy. Put simply, bank balance sheets can’t absorb the cash the Fed is making available to them.
Some observers say the Fed is solving for the last crisis, administering the same medicine it did in 2008 when banks were leveraged and could deploy capital at will to counterparties.
“This time around, markets are experiencing a crisis of collateral quantity and not collateral quality,” said Joshua Younger, head of interest-rate derivatives strategy at JPMorgan Chase. “The assets that form the epicenter of this particular crisis are in fact risk-free: Treasury bonds.”
Asset managers and hedge funds were dumping Treasurys and other safe assets last week in a bid to raise cash to meet margin calls and redemptions, quickly overwhelming dealer balance sheet capacity.
One potential solution that dealers say could free up balance sheet is the Fed could lend cash directly to smaller banks, securities dealers and hedge funds in a process known as sponsored repo through the Fixed Income Clearing Corp., or FICC.
Some veterans of the government’s response to the 2008 financial crisis are urging the Treasury and the Fed to support the economy by using an obscure pool of money at the Treasury called the Exchange Stabilization Fund, which has around $94 billion in it. They say such a program could backstop additional schemes to get cash to strapped businesses and health-care systems until Congress provides more explicit funding.