In a rare event, the U.S. Treasury and the U.S. Federal Reserve (the Fed) have had a very public disagreement about the extension of several of the credit facilities used to backstop credit markets and increase financial stability. The risk is that an important source of financial market support is removed at a time when the economy is facing increasing downside risks from fading fiscal support and weaker levels of economic activity associated with higher COVID-19 case numbers.
The facilities in question are those which are funded by the Coronavirus Aid, Relief, and Economic Security (CARES) Act, including the primary and secondary corporate credit facility, the municipal lending facility, term asset-backed securities loan facility and the main street lending facility. Only these programs will be removed come year end and were initially designed to extend cheap loans to small and medium size companies, municipalities as well as households. The other facilities, which are designed to ensure ample market liquidity, such as the commercial paper funding facility, have been extended until the end of March 2021.
The CARES Act funding allowed for USD 454billion (bn), which the Fed could lever up to originate new loans, purchase assets and protect itself from losses. The ability of the Fed to lever up this initial funding meant that the theoretical limits of the facilities were much higher. USD 195bn of the initial funding was allocated to the credit facilities, which are now ending and most of the funds were used in the primary and secondary corporate credit facilities and the main street lending facility. The Treasury is asking for the unused portion of the funds, but the exact amount is unknown, as there are still issues regarding current outstanding loans that the facilities have made.
The rationale is that these programs have done their job, as indicated by healthier markets and their limited use. Exhibit 1 shows that the actual take-up of many of these facilities was far lower than the maximum potential. Meanwhile, the bond market in the U.S. is in much better shape than when these facilities were first introduced and the medium-term outlook for the economy is superior to nine months ago. However, the sentiment effect of having the backstop of the two corporate credit facilities was a powerful driver of that improvement. The spread tightening that occurred in March came after the announcement of the facilities and well before they were actually applied. The consequences of not having that sentiment support could be dire, should the market experience another crisis.
As central banks’ palettes of policy tools have expanded since the global financial crisis and more recently the COVID-19 crisis, they have been unwilling to give up these new measures. The Fed is no different, preferring to retain all the options at its disposal, even if they are unused, to ensure stability in financial markets and achieve employment and inflation mandates.
Exhibit 1: United states: monetary policy
Source: Bloomberg Finance L.P., FactSet, U.S. Federal Reserve, J.P. Morgan Asset Management. The Federal Reserve’s credit facilities include the Commercial Paper Funding Facility (CPFF), Primary Dealer Credit Facility (PDCF), Paycheck Protection Program Lending Facility (PPLF), Corporate Credit Facility (CCF), Municipal Liquidity Facility (MLF), Money Market Mutual Fund Liquidity Facility (MMLF), Term Asset-Backed Securities Loan Facility (TALF) and the Main Street Lending Facilities, which include the Main Street Expanded Loan Facility (MSELF), Main Street New Loan Facility (MSNLF) and the Main Street Priority Loan Facility (MSPLF).
Data reflect most recently available as of 23/11/20.
Investment implications
The investment implications of ending the lending facilities may seem limited, given that many of these facilities were only used lightly, but the most successful programs are often the ones that don’t need to be used. The fact that they exist is enough of a signal to send markets on the right path. It will be the sentiment effect at a time of U.S. economic strain that could have the greatest short-term impact on markets. In the medium term, things are less worrying.
The current U.S. administration will come to an end on the 20th of January, at which point the new administration and U.S. Treasury Secretary could reestablish the programs. There are funds available via the Exchange Stabilization Fund, which is used to support the continuing U.S. Treasury – Federal Reserve facilities into next year. The amount available through the ESF is around USD 70bn, which may limit the sentiment impact from the perspective that this would look like reduced firepower. Meanwhile, the return of the funds from the Fed to the Treasury means that there is more money in the pot which Congress could allocate elsewhere or potentially increase the size of any stimulus package in the new year.
What does this all mean for the Fed? The Fed has hinted heavily that a change to the current policy setting is coming at its December meeting and the decision not to renew facilities may add a little more downside risk to the Fed’s view, but does not inherently create a greater impetus to act.
For markets, particularly U.S. credit markets, the worst appears to be behind them. The improving economic outlook expected from the second half of next year and the potential upside risk from an earlier arrival of a COVID-19 vaccine create a supportive outlook for U.S. corporate debt. The expectation that government bond yields will remain low as inflation rates remain low means that investors will remain attracted to the relatively higher yields on offer from investment-grade and high yield bonds.
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