The Fed and the Department of Public Works

By Deron T. McCoy, CFA®, CFP®, CAIA®
Chief Investment Officer

Perhaps there’s no easier way to put people to sleep then by talking at length about the Federal Reserve. All I need to do is mention the words ‘repo rate’ or ‘discount window’ and most people’s eyes start glazing over as they stifle a yawn. But wait…bear with me for just a second.

Over the weekend, investors were anxiously waiting to see if the Fed would again cut interest rates, perhaps even moving the short-term Fed Funds rate down to zero. And in dramatic fashion on Sunday, the Fed took rates to zero. While the move might help loosen financial conditions, it’s not the main problem that deserves our attention. Jim Grant of Grant’s Interest Rate Observer reminds us that “interest rates are prices,” and while the cost of money is important, it’s not the be-all and end-all.

Still with me? Let’s look at a real-life analogy to make this all a bit less academic and dry.

Say you’re remodeling your house and looking to add one of those new luxury “overhead rain showers.” The cost of the system is a consideration – so, if at some point the store lowers that cost, it’s a positive. But what if the real problem is that the plumbing doesn’t work? And it’s not just a problem at your house – it’s everywhere! You would expect the city to do something, right? What if instead the public works department turned around and mandated that the cost of all bathroom fixtures be $0, it doesn’t exactly solve the problem, does it? Nobody cares whether their shower is free if it’s going to fill with water that won’t drain. Instead—the city government must focus on fixing the plumbing!

Everyone knows that stocks have had a historic selloff. But the ultra-safe government bond market was malfunctioning as well. According to CNN, “even though Treasuries are supposed to be the safest assets on the planet, liquidity dried up in that market, setting off alarm bells on Wall Street.”

In short, the plumbing and inner workings of the financial system were broken.

If investors are to remain confident in the system, markets need to properly function, and ETFs need to correctly price. And if corporations are to remain solvent, credit needs to flow easily back and forth with access to short-term funding markets and commercial paper. Should society for any reason lose faith in the system, the whole thing falls apart (the word ‘credit’ actually derives from the Latin root word ‘cred’ which means ‘believe’).

We are not alone in thinking this. James Bianco, president of Bianco Research on CNN Thursday observed, “There is no liquidity in the markets…financial markets are seizing up.” Chief Investment Officer Peter Boockvar further added, “The market in a sense broke today,” noting the gap in Treasury bond prices as signaling a liquidity crunch.

Fortunately, with the announcement of ZIRP (zero interest rate policy) came QE4 (Quantitative Easing Part IV) to try and fix the plumbing. Mr. Bianco added on CNBC “What the Fed did was they restarted QE, and they essentially announced that in the next two days they’re going to do more QE than they did in the last five years combined. The reason they’re doing it is because the financial markets have stopped functioning properly. There’s no liquidity. There’s hardly any trading.” Jeffrey Kleintop of Charles Schwab added, “This is to make sure banks don’t have any funding issues…We don’t want companies to feel like banks will pull back on their lines of credit and run into liquidity problems.”

According to PIMCO, however, “these actions ultimately may not be enough. Trading conditions in other markets are also strained” with agency mortgages trading at 2008 financial crisis levels. In their parlance, “pressures in that market are hindering the effective transmission of monetary policy.” That’s a bond analysts’ way of saying that every city needs an ‘effective transmission’ to keep your rainwater moving through the plumbing system getting it out of town. They had suggested that the Fed also needs to signal a willingness to “do whatever it takes to support markets. And to further ease financial conditions, the Fed could announce broader plans to purchase (other) assets while also emphasizing that it stands ready to initiate targeted support to markets as needed in the event of further stress.”

Which is why the news on the morning of March 17 was so welcomed by global capital markets. The New York Times article, “Fed Unveils Emergency Lending Program to Shore Up Credit Markets” stated that the new program, “enacted using the Fed’s emergency lending powers, pulls a page from the central bank’s 2008 financial crisis playbook and is an attempt to keep the economy and financial system functioning by backstopping a market that some of America’s biggest companies use to raise cash.
Banks and companies have been issuing commercial paper to shore up their coffers as coronavirus leads to quarantines, shutters shopping centers and closes restaurants. But hardly anybody has been buying the debt. Treasury Secretary Steven Mnuchin, whose department will provide $10 billion of credit protection to the Fed using the Treasury’s Exchange Stabilization Fund, said the facility would allow the central bank to buy up to $1 trillion worth of commercial paper “as needed.”

CNN likens the problem to an engine, “the bond-trading engine seized up, and the Fed added oil to make it run smoothly again.” Well said!

Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Royal Alliance Associates Inc. Securities offered through Royal Alliance Associates, Inc. member FINRA/SIPC. Investment advisory services offered through SEIA, LLC, 2121 Avenue of the Stars, Suite 1600, Los Angeles, CA 90067, (310) 712-2323. Royal Alliance Associates, Inc. is separately owned and other entities and/or marketing names, products or services referenced here are independent of Royal Alliance Associates, Inc.

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