By Robin Marshall, Director, Fixed Income.
The Fed recently broadened the range of assets it will buy in Quantitative Easing (QE) programs, to include corporate bonds and sub-investment grade issues, supplementing US Treasuries and (agency) MBS. Given the severity and broad-based nature of the shock to the US economy from the coronavirus, this begs the question as to whether the Fed will follow the Bank of Japan’s lead and include US equities in its range of QE assets?
To answer the question, the Fed’s QE programs should be seen in historical context. The Fed first adopted “unconventional” monetary policy in 2008/09, as it became clear that to supply further stimulus to the US economy, zero interest rate policy (ZIRP) alone would not restore full employment and stable inflation. QE policies have since comprised asset purchase programs, of varying size and duration, to supplement adjustment of policy interest rates and forward rate guidance.
Early QE policies began with US Treasuries and MBS to solve a credit crunch
During the GFC (and its aftermath), the policy focus was on easing the “credit crunch” on companies and households, by driving down the cost of capital, and unfreezing housing market finance after the collapse of the sub-prime mortgage market. This was achieved by buying US Treasuries and (agency) mortgage backed securities (MBS). The Fed also bought US Tips to prevent the entrenchment of very low inflation expectations and introduced a formal inflation target in 2012 (of 2%). In expanding QE, the Fed’s balance sheet grew from under $1trillion in September 2008 to over $5 trillion today, as the chart below shows.
Fed balance sheet
Source: FTSE Russell / Refinitiv. Data as of April 2020.
But the coronavirus shock led to broader QE, and lower asset quality criteria
The current economic shock from the coronavirus poses new and broader challenges for the Fed. Narrow focus on the financial system and housing market, drove early QE programs. The evolution of Fed policy since the coronavirus shock began in Q1 is shown in the table below. Initially, the Fed deployed more of the same QE from the GFC, re-instating zero interest rates and resuming US Treasury and MBS purchases. But as the severity of the shock grew, the Fed has broadened the range of assets purchased in its QE programs and lowered the asset quality criteria for those purchases.
Chronology of key Fed policy announcements during Coronavirus Crisis
March 3-15: Fed funds rate cut to 0-0.25% zero again
March 15: Resumption of QE programs – $500bn in US Treasuries, $200bn in (Agency) MBS purchases over coming months
March 23: Term Asset-Backed Securities loan Facility (TALF) announced to support credit flows to consumers and businesses. Establishment of Corporate Credit Facility. Pledge to go beyond $700bn in US Treasury and MBS purchases
April 9: Primary and Secondary Market Credit facility of up to $750bn, allowing purchases of corporate bonds, including high-yield ETFs. Various programs to ensure credit flows to small and mid-size businesses. A Municipal Liquidity facility of up to $500bn for lending to states and municipalities
Will this range of QE assets be sufficient?
With the Fed now prepared to purchase, or lend against, assets as diverse as US Treasuries, MBS, Munis, investment-grade and high-yield credit, this shows a journey towards buying riskier assets to broaden the impact of QE.
Lowering the quality of assets in QE programs increases risks to the Fed’s balance sheet. However, if the Fed simply buys risk-free assets like Treasuries when monetary policy is near, or in a liquidity trap, it is unlikely to boost growth or inflation.
The big asset class not currently included is equities. The chart below shows that buying equities might help put a safety net under household net worth because of the correlation between household net worth and equity valuations. If so, this would prevent a collapse in consumer confidence and expenditure from reinforcing deflationary pressures.
US equities and household net worth
Source: FTSE Russell / Refinitiv. Data as pf April 2020.
Recent Fed move to include high yield bonds may prove significant
Buying equities – a much bigger asset class – would also supplement the support for companies from the corporate bond purchases, announced on April 9. Indeed, it could also be argued the Fed has already risked moral hazard by making corporate bond purchases, including high-yield credit, so it would not be a big further step to buy equities.
Finally, given that the Bank of Japan has been buying equity ETFs since April 2013 as part of a Quantitative and Qualitative Easing program, the Fed would not have a first mover disadvantage.
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