Khan Capital | March 2020
In the span of two weeks, the Federal Reserve has deployed the most aggressive monetary policy response in its 107-year history. On 3 March, the Fed delivered an emergency 50-basis-point cut. On 15 March, a Sunday evening, it cut again by 100 basis points to 0-0.25% and launched a massive $700 billion quantitative easing programme. It established nine emergency lending facilities. It extended dollar swap lines to 14 foreign central banks. The Federal Reserve has gone nuclear.
The Context: A Pandemic Meets a Liquidity Crisis
The S&P 500 fell 34% in 23 trading days from its 19 February peak. But the real danger was in credit and Treasury markets, where basic functions were breaking down. The US Treasury market experienced severe dysfunction with bid-ask spreads widening to 2008-crisis levels. Corporate bond markets froze. The dollar surged approximately 8% in two weeks as the global dollar scramble intensified.
The Response: Everything, All at Once
Zero interest rates. The FOMC voted during two unscheduled meetings on 3 and 15 March to reduce the federal funds rate by a total of 1.5 percentage points, dropping it to near zero.
Unlimited QE. The Fed purchased over $1 trillion in securities in the first three weeks, expanding its balance sheet from approximately $4.2 trillion to $7 trillion by June 2020. The Congressional Research Service noted that in April alone, the Fed’s securities holdings increased by about $1.2 trillion.
The alphabet soup of facilities. The Brookings Institution documented nine emergency lending facilities targeting specific market segments: PDCF, CPFF, MMLF, PMCCF, SMCCF, TALF, MLF, Main Street Lending Programme, and PPPLF. For the first time in its history, the Fed purchased corporate bonds and even high-yield bond ETFs.
Dollar swap lines. The Fed extended unlimited swap lines to five major central banks and established new lines with nine additional central banks, addressing the global dollar funding shortage.
What the Market Is Misunderstanding
The Fed is backstopping the credit system. When commercial paper markets freeze, companies cannot fund payroll. When muni bond markets seize, hospitals cannot borrow. The facilities are designed to prevent a liquidity crisis from becoming a solvency crisis.
The precedent being set is enormous. By buying corporate bonds and high-yield ETFs, the Fed has crossed a Rubicon. This precedent creates a permanent implicit guarantee for corporate credit.
The scale of balance sheet expansion will have consequences. The seeds of the 2021 meme stock mania, the SPAC boom, and the crypto euphoria are being planted in the Fed’s emergency response.
The fiscal-monetary coordination is unprecedented in peacetime. The CARES Act appropriated up to $500 billion through the Exchange Stabilization Fund to support the Fed’s emergency facilities, creating a fiscal-monetary fusion that is a profound departure from institutional separation.
Implications for Investors
“Don’t fight the Fed” is the dominant investment principle. Zero rates, unlimited QE, and direct credit market support create the most accommodative financial conditions in history.
Credit markets are being explicitly backstopped. The PMCCF and SMCCF effectively guarantee that investment-grade issuers can access funding.
Inflation is not a near-term risk, but it is the medium-term consequence. The combination of unprecedented monetary expansion and massive fiscal stimulus will eventually reflate prices.
Conclusion
The Federal Reserve has deployed the most powerful monetary intervention in its history. The immediate objective is being achieved. But the long-term consequences will define markets for a decade. The Fed has saved the system. The question now is what kind of system it has created.
Key Takeaways
- The Fed cut rates to zero and launched unlimited QE within two weeks, the most aggressive monetary response in the central bank’s 107-year history.
- The balance sheet expanded from $4.2 trillion to $7 trillion by June 2020, with over $1 trillion purchased in the first three weeks alone.
- For the first time, the Fed purchased corporate bonds and high-yield ETFs through nine emergency lending facilities, creating a permanent implicit guarantee for corporate credit.
- Dollar swap lines to 14 central banks addressed the global dollar funding shortage.
- The unprecedented scale of monetary and fiscal coordination prevented a financial system collapse but planted the seeds of future asset price inflation, moral hazard, and speculative excess.
Sources: CNBC, Congressional Research Service, Brookings Institution, Federal Reserve Bank of St. Louis, Federal Reserve Board
Related Reading
For the market crash that triggered this emergency response, see COVID-19: The Fastest Bear Market in History. The earliest signs of the inflationary consequences emerged in The Inflation Debate: Team Transitory vs. Team Persistent. Those consequences fully materialised as covered in Inflation Hits 6.8%: The Fed Retires ‘Transitory’, leading to The Great Taper: Fed Signals End of Easy Money Era and The Fed’s Most Aggressive Hiking Cycle in 40 Years Begins. For how zero rates contributed to the meme stock phenomenon, see GameStop and the Meme Stock Revolution. For context on the broader retail investor phenomenon that reshaped market dynamics from 2020 onwards, see the rise of retail trading. The institutional adoption wave that transformed Bitcoin from retail speculation to portfolio asset is explored in Bitcoin’s institutional moment. The Pfizer vaccine announcement that repriced the end of the pandemic is covered in Vaccine Day. The uneven nature of the post-COVID recovery is examined in the K-shaped recovery. The fiscal response that complemented the Fed’s monetary intervention is covered in the CARES Act. The liquidity crisis that preceded the Fed’s emergency response is detailed in the March 2020 liquidity crisis. The repo market plumbing problems that preceded the COVID crisis are covered in the September 2019 repo crisis.
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