The rapid succession of launches through this week of the Federal Reserve’s 13-3 “alphabet” facilities, dusted off and updated from their initial construction amid the 2008 crisis, seem to be having their intended accumulated impact in easing the spectacular strains and stresses across the global fixed income markets.
** The volatile, mind-scarring volatility in treasury yields has been triggering no small amount of market speculation over whether the Fed will soon be introducing yield curve caps. Fed officials, we understand, believe the yield swings are being in large part driven by the unwinding of massive leveraged positions and the de-risking by the banks and dealers. They do not believe the higher yields reflect a signal for a sustained tightening in financial conditions that would run contrary to the Fed’s intended accommodation.
** Our sense is that some form of a yield curve cap or caps is coming, but we are hesitant to say it will be imminent, or intended as a crisis management tool, at least not before the Fed has exhausted its menu of additional, more targeted vehicles to whack the moles of market strains and stresses before they spill over into a truly systemic threatening fractures. So as such, “acting as appropriate” would entail more of the tailored liquidity measures already undertaken or being developed, and which, hopefully, will reach to where the liquidity is needed the most to cushion the disruption of these unwinds.
** A turn to yield curve management, on the other hand, either through a cap at, say, the two year, or along the entire curve as was the practice during the Second World War, we believe is more likely to be undertaken, optimally, only after further lengthy discussions and a consensus vote by the Federal Open Market Committee. But for now, we are not aware there is anything like a solid FOMC consensus on this yet.
** On that point of a policy consensus, yield curve management is meant as a key cornerstone to the Fed’s unfolding policy strategy now that the policy rate is again pinned to the Zero Lower Bound. YCC would be a more natural and reasonably seamless transition from the currently expanding QE asset purchases into a pro-cyclical balance sheet tool coupled to an aggressive “lower for longer” rates forward guidance – and crucially, a firm underpinning of fiscal stimulus leading the way.
** As such, we believe the FOMC would see a yield curve cap intended as a quick cooling of the spikes in treasury yields as a premature and misplaced response to the current market dislocations, and which could potentially undermine its later potency.
** There are also a few practical matters that would need to be sorted out before the Fed can unveil yield curve caps. For one, the Fed will need to have a firmer handle on just how large Congress will go in its political and legislative response to the coronavirus disaster, and thus a sense of just how much new debt is going to be raised in the capital markets. From the Fed perspective, we suspect they would say if asked, the bigger the better.
** That, in turn, would also require discussions and guidance from Treasury on where along the curve the new issuance is likely to come. This may not necessarily require a formal new “Accord” to define the relationship between the Fed and Treasury, but we likewise doubt this can be slapped together or be based on a back of the envelope estimate.
** Above all, Fed officials will want to weigh carefully the consequences of going back to the yield curve management they undertook during the Second World War, as it will entail profound and fundamental changes in the institutional and operational independence of the Federal Reserve going forward. It will be hard to close that door once opened.
And on the additional crisis management measures:
** Our sense of the Fed’s current crisis management thinking – and we can only imagine what hours are being put in — is that the Fed is not thinking of YCC as a liquidity tool to currently put to use, but are instead still extremely focused on moving forward with additional alphabet facilities to target a smoothing of market functioning.
** We understand many Fed officials have been frustrated with the dealer/banks and that the massive repo operations have not been reaching to where the liquidity is needed. But, on the other hand, there looks to be an accumulative calming across most of the markets in the wake of the QE purchases, the flood of repo, and the string of new targeted facilities and swap lines. So we still expect more of what could be best described a market functioning targeted vehicles, among them:
** The one at the top of the Fed menu, we believe, is a reworked version of the 2008 Term Asset-Backed Securities Loan Facility (TALF), in which the Fed purchased newly originated asset-backed securities. There is no way of knowing with certainty, but we believe its likely reincarnation will entail a fine tuning to reach a targeted small to medium sized business sector, and with perhaps looser credit ratings than just AAA paper. Whatever its final form, a TALF or a similar vehicle will require Treasury authorization and a credit backstop, either from Treasury through its Exchange Stabilization Fund or from Congress in one of the huge fiscal stimulus bills storming across Capitol Hill (the original TALF was funded through TARP money).
** We were a little surprised, earlier this week anyway, that the Fed did not turn first to its Term Auction Facility as the first of the 2008 facilities to be unveiled in the current crisis. Since it is more or less a glorified discount window facility, priced through an auction rather than an administered penalty rate and open to any qualified institution, it does not entail a Section 13-3 authorization from Treasury or require credit backstops, and so would thus have been the easiest and quickest vehicle to push liquidity out.
** But on the other hand, we understand that in the Fed’s assessment of where the market stresses lie, for a number of reasons, potentially with the regulatory restraint on the balance sheet, the problem is not the dealer/bank access to liquidity but that they not pushing their access to Fed liquidity further out into the broader market. But it could still come around the corner, once some of the other clogs in the liquidity pipeline are cleaned out.
** For instance, some of the most potent fixes the Fed has managed this week have been in the micro details often lost in the confusing rush of acronym facilities. For instance, the best bit of the Primary Dealer Credit Facility was in the loosened and expanded collateral being accepted, which means dealers could unload just about everything they want off their balance sheet for cash. And we understand that any money market fund commercial paper put back to the Fed under the terms of last night’s Money Market Mutual Fund Liquidity Facility will not trigger regulatory capital or liquidity charges, thus freeing up more balance sheet room. Other critical regulatory relaxations are likewise being weighed.
** The Fed also, cautiously, expanded the list to nine of foreign central banks given access to the dollar swap facility, but there is a fairly tight six-month expiration on it, and we would not be surprised to see the International Monetary Fund issue a new allocation of special drawing rights before too long. There is no point in waiting for the spring meetings since they will all be by teleconference anyway, and an SDR release or even hefty IMF new loan facility out of existing resources would provide a backdoor way of shoveling dollars more broadly into the emerging market economies.
** The Fed has historically been loath to extend swap lines beyond the big five foreign central banks because of political concerns the dollar liquidity can quickly become loans never paid back. So better to have the IMF as the counterparty to a massive injection ofa dollar liquidity into emerging markets where high dollar corporate debt and global supply chain subsidiaries are gasping for dollars.
** Fed officials had been hoping their dramatic “all in” on Sunday night in dropping rates back to a 0-25bp range, the additional QE, the lower discount window rate, and some of the regulatory tweaks would be enough to buy them some time for the follow through in unveiling the additional alphabet facilities from the 2008 crisis, especially since under the Dodd Frank restriction on its 13-3 powers, all but the TAF requires Treasury Authorization and ideally, credit and funding backstops from Treasury or Congress. Things did not quite work out so smoothly, but the hope is markets may steadily calm down by the weekend. Everyone needs a breather.