The Fed fine-tunes its response
The Federal Reserve has made many crucial and successful moves in the wake of the Covid-19 crisis, and we have been among the first to applaud them. But what it has done since also has been impressive. Policymakers have not ceased in their effort to bring the instrument that is the economy back in tune.
The Fed has been reassessing the effectiveness of its new rates, facilities, purchases and programs, and adjusted them or added more. The easiest way to see this is how large its balance sheet has become, rising from $4.3 trillion in mid-March to $5.8 trillion in early April to around $6.7 trillion at month-end. And the number will only grow from here. If that is not a sign of the Fed going all in, I don’t know what is.
We may see alterations to Fed facilities in the coming weeks. All of the major money market programs have declined in usage. It would not surprise us to see the Fed reduce the amount of lending offered for the Money Market Mutual Fund Liquidity Facility (MMLF), Primary Dealer Credit Facility (PDCF) and Commercial Paper Funding Facility (CPFF). That the latter has only collected around $3 billion shows that direct issuers are no longer having the liquidity issues of getting their paper placed in the marketplace with traditional counterparties and investors. Certainly, the CP market is normalizing, with the London interbank offered rate (Libor) falling and spreads narrowing. Across the industry, around half of the assets lost in the prime space came back in April, government funds are still seeing inflows and municipal funds are at their high-water mark in assets for the year.
The Fed increased the amount and frequency of overnight and term repo to facilitate market functioning in response to the coronavirus-caused dislocations in March, offering up to $1 trillion per day in overnight transactions, as well as through several $500 billion term operations. But with the improvement in the funding markets the usage of these operations has been quite small, and the Fed will cut back these amounts beginning May 2. Aided by increased government issuance to fund the stimulus packages, bill yields traded in positive territory in the secondary market throughout April, suggesting that the dip into negative territory in March will not be retested.
A recent fine-tuning by the Fed came in the municipal space. On April 27, it announced a massive expansion to its new Municipal Lending Facility for state and local governments. When it unveiled the program on April 9, only states, counties with at least two million residents and cities with at least one million qualified. After further research—and just plain listening to constituents—it lowered the threshold to include counties and cities with at least 500,000 and 250,000 residents, respectively. When the facility begins in May, this broader boundary line should help municipalities recover from deferred or lost revenue and create more supply for municipal funds.
One change that we at Federated Hermes and other cash managers had expected to occur was to overnight rates. But the Fed disappointed. When it met Wednesday (April 29), the Federal Open Market Committee did not raise the level of the reverse repo program (RRP) from zero to 5 basis points and the interest on excess reserves (IOER) from 5 to 10 basis points. Many thought the Fed needed to do this to take more control of the federal funds rate, but for now that was not the case. The FOMC reaffirmed it would do all it can to stem the economic damage caused by the coronavirus and subsequent U.S. lockdown. In fact, Chair Powell hinted the Fed could do even more, and it would not be surprising to see implementation of a formal quantitative easing (QE) program or to expand the programs already in place. In fact, given the Fed’s remarkable nimbleness during the crisis, we anticipate it.
As for our purchases, we are buying across the short-end of the curve, engaging in maintenance trades to keep our funds in their weighted average maturity ranges. Throughout all of the turmoil, we kept our ranges at 35-45 days for government and 40-50 days for prime and municipal portfolios. Obviously, it has been hard to keep numbers within these ranges and value is hard to uncover. But we continue to have ample liquidity in all portfolios. The good news is that the Treasury and Libor curves are normalizing and upward sloping, and Sifma has retreated from its dislocated highs of more than 5% in mid-March to double-digit basis-point territory currently. As such, we consider the liquidity markets reasonable in this current low-rate environment.