Economic Reflections

Market Liquidity and the U.S. Federal Reserve | April 6 – 10, 2020

by | Apr 13, 2020 | Economic Reflections

While much of the world’s attention during the COVID-19 pandemic understandably has been focused on the dramatic effects on health, jobs, social interactions, and family finances, the US Federal Reserve (the Fed) has been leading an aggressive effort to keep the underlying mechanisms of our financial system functioning. They have drawn from a playbook developed during the Great Financial Crisis (GFC) of 2007-2009, lowering interest rates and asset purchases, while also introducing new programs to ensure that the fixed income markets that undergird our financial system remain liquid.

The Fed’s efforts (see partial list of programs below) strive to ensure that the economy’s underlying financial system is functioning so that this liquidity crisis, created as a result of global social distancing, does not lead to an insolvency crisis for many corporations and consumers. The Fed’s programs have been aimed at reducing borrowing costs, easing dollar funding stress, ensuring the flow of credit to households and businesses, and helping state and local governments.

This last week alone, the Fed said it will invest up to $2.3 trillion in loans to aid small and mid-sized business and state and local governments, as well as fund the purchases of some types of high-yield bonds, collateralized loan obligations, and commercial mortgage-backed securities (Source: Bloomberg). Previously, the Fed had committed to purchasing investment grade and asset-backed securities. As a result of the announcement this past week, the Fed has intervened in almost every sector of the fixed income market to provide liquidity or support.

We have already seen the benefit of this activity in credit markets, with mortgage-backed securities, investment-grade bonds, and high-yield bonds rebounding, 1.2%, 8.6%, and 12.3% respectively from the March 23 market lows (Source: Morningstar). As we mentioned in our commentary last week, companies that have been most impacted by “social distancing” have been able to access capital through the credit markets to shore up liquidity until we restart our economy.

The Fed is not the only central bank to pump liquidity into their underlying financial system through asset purchases and lower interest rates. The Bank of Canada, European Central Bank, People’s Bank of China, Bank of Japan, and many more have enacted some of the same measures, though on a smaller scale. It is estimated that globally, 3,200 basis points of rate cuts have happened since January 2020 (Source and Graph KKR; April 9, 2020).

We applaud the speed and magnitude with which central banks globally have responded to this crisis, the Fed in particular. Unfortunately, we must see the COVID-19 curve flatten to get a better understanding of when the economy can restart and thus better assess whether more support will be needed. However, we are comforted by comments from Fed Chair, Jerome Powell, who stressed that the Fed is committed to using all its tools to support the flow of credit to households and businesses to counter the impact of the pandemic. The combined fiscal and monetary response has been extraordinary; indeed, the latest Fed announcement plus the $2.0 trillion of fiscal stimulus in the CARES Act equates to about 20% of annual U.S. gross domestic product (GDP).

As we evaluate both the fiscal and monetary programs and the long-term effects on our capital markets, we also are considering the long-term implications for our society in general. The programs below are not designed to last forever. So just as we face much work to better understand how to counter the spread of infectious diseases, so, too, must we collectively consider how to design and implement a more resilient and sustainable economy.

A Partial List of U.S. Federal Reserve Liquidity Programs (as of April 10, 2020)

TALF (Term Asset-Backed Securities Loan Facility):  TALF has been reintroduced from the GFC to provide up to $100 billion to support new issue AAA-rated Asset-Backed Securities (ABS) backed by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. Under TALF, the Fed will lend money directly to investors to purchase these Asset-Backed-Securities (ABS), ensuring demand for these products and the ongoing availability of consumer credit in specific areas.  On April 9, the Fed expanded TALF to include AAA-rated outstanding Commercial Mortgage-Backed Securities (CMBS) and new issue Collateralized Loan Obligations (CLO).

CPFF (Commercial Paper Funding Facility):  CPFF has been reintroduced from the GFC to serve as a backstop to the Commercial Paper market. Commercial paper is used primarily by corporations and municipalities to meet short-term operational cash needs (e.g., payroll, inventory, etc.). The Fed’s intervention will come in purchases of these obligations from issuers, essentially shifting risk to the U.S. Government and ensuring this market continues to operate as usual.

MMLF (Money Market Mutual Fund Liquidity Facility): MMLF has been reintroduced from the GFC to serve as a backstop to the money market mutual fund industry.  Money market mutual funds function as a destination of safety by guaranteeing a $1.00 net asset value (NAV). These mutual funds invest in a variety of short-term, cash alternative investments that have values that fluctuate, albeit in relatively small magnitudes. Mass redemptions from money-market funds threaten a manager’s ability to sell underlying securities and thereby meet dollar-for-dollar redemptions. Under MMLF, the Fed will lend money directly to eligible banks to purchase certain assets directly from money market mutual funds, ensuring ongoing functioning of the money market industry.

PDCF (Primary Dealer Credit Facility): PDCF has been reintroduced from the GFC to provide an unlimited supply of funding to the Fed’s primary dealers, a group of 24 financial institutions that serve as trading counterparties of and market-makers for the Fed. The PDCF allows primary dealers to access short-term loans for terms up to 90 days, thereby helping ensure the ongoing function of financial markets generally. Primary dealers can pledge a broad array of collateral against these loans.

PMCCF (Primary Market Corporate Credit Facility): The PMCCF is a new facility to facilitate the purchase of new-issue investment-grade corporate bonds with a maximum maturity of four years. The PMCCF’s primary goal is to ensure investment-grade corporations can continue to access bond markets to raise cash so they can maintain business operations during the pandemic. On April 9, the Fed expanded the overall size of PMCCF and broadened it to include certain new-issue high yield corporate bonds.SMCCF (Secondary Market Corporate Credit Facility): The SMCCF is a new facility aimed to help ensure ongoing liquidity within the secondary corporate debt market. This new facility also gives the Fed new authority to directly purchase corporate bond exchange-traded funds (ETFs) to stabilize prices of those securities after recent trading hit a 20% discount to net asset value (NAV).  On April 9, the Fed expanded the size and scope of the SMCCF to include certain high-yield bonds and high-yield bond ETFs.

MSLP (Main Street Lending Program): The MSLP is a new facility aimed at providing up to $600 billion of credit to small and mid-sized businesses that were in good financial standing before the pandemic crisis. The facility will offer four-year loans to businesses with up to 10,000 employees or with revenues up to $2.5 billion. The program allows for principal and interest payment deferrals for one year. Under the MSLP terms, borrowers will need to adhere to certain requirements and restrictions that apply to the PPP loan program established by the CARES Act. Similarly, businesses that utilize the MSLP will need to make “reasonable efforts” to maintain payroll and retain workers. A business that utilizes the PPP may also take out a loan through the MSLP.

MLF (Municipal Liquidity Facility): The MLF is a new facility to aid US state and local governments to manage cash flow pressures and continue to serve their communities during a period of dramatic tax revenue declines. The facility will purchase up to $500 billion of short-term municipal notes directly from states and larger cities and districts.