We Are Going To Buy Your Bonds Whether You Want Us To Or Not

Today the Federal Reserve announced they are expanding their corporate bond buying program. Via Victoria Guida at Politico:

The Fed is going to create an index of U.S. corporate bonds that it will purchase on the open market as long as they meet eligibility standards — an approach that will spare the companies from having to seek aid directly from the central bank.

The goal of the $750 billion emergency lending program is to keep cash flowing in the markets and support “the availability of credit for large employers,” the Fed said on Monday. Stocks rose on the news, reversing sharp losses earlier in the day.

The announcement represents a shift in strategy for the central bank, which was previously only going to buy individual bonds issued by companies that approached it directly. Now the Fed will buy bonds of all eligible companies, whether they ask or not.

Brian Chappatta at Bloomberg wonders why the Fed is doing this at all:

The most surprising part of this is there is virtually no evidence that the corporate-bond market needs this kind of intervention — it has been working nearly flawlessly for months.

This does create a bit of a problem for my narrative (not that it’s all about me). I  have typically described the Fed’s asset purchase program and lending program in terms of market functioning. The Fed identifies a gap in the credit market and tries to bridge that gap. In some cases, bridging the gap might be possible by simply being a credible backstop to a credit market. This appeared to be the case in the corporate debt market. Just the willingness of the Fed to prevent a liquidity crisis from becoming a solvency crisis was enough to revive the corporate debt market. As Chappatta noted, the market appeared to be functioning just fine. So why the extension of the program? Isn’t the best case scenario the one in which the Fed can stabilize credit markets without actually buying anything?

This isn’t the first time the Fed has done something like this. Last week, the Fed put a floor under the asset purchase program by holding it “at least at the current pace to sustain smooth market functioning.” Heather Long at the Washington Post quickly eyed the logical conundrum:

Hi, good afternoon, Chair Powell. I’m struggling with two things that I’m hoping you can provide some clarity on. The first is the ongoing bond buying program. You say that it’s needed to continue the smooth functioning of markets, but I guess most of us aren’t really seeing instability in markets right now. So, if you could kind of give us some clarity of what you’re seeing that needs to continue to be smooth at that level and that pace.

Powell responds:

CHAIR POWELL. There have been gains in market function, although not fully back to where you would say they were, for example, in — in February, before the pandemic arrived. We don’t take those gains for granted though. This is a — this is a highly fluid situation and we’re we’re not taking those for granted. And in addition, as I pointed out in my — in my statement, those purchases are clearly also supporting highly accommodative — or accommodative financial conditions, and that’s — that’s a good thing, so that’s why we’re doing that.

It is not a particularly satisfying answer. It doesn’t fully embrace that asset purchases are increasingly less about market functioning and increasingly more about accommodative financial conditions. In other words, quantitative easing does not just allow for the transmission of accommodative interest rate policy, but is accommodative policy by itself. I discussed this Monday in my Bloomberg column. The Fed did a stealth easing last week and it kind of flew under the radar.

After today’s bond market news, I am more convinced that the Fed is rapidly moving beyond market functioning but not being very direct about that move. It is fairly easy to conclude that the Fed is working to push down interest rates (or push up prices) across a range of financial assets but not directly saying this is the Fed’s objective. I understand why they want to pursue such a policy. I don’t understand why they don’t just say they are pursuing such a policy.

The Fed’s behavior this past week does give us a clue on how yield curve control is going to work. In theory, an advantage of yield curve control is that the Fed could control interest rates by just promising to purchase debt at a certain price. The promise alone should be effective with minimal actual purchases. Just as the Fed’s promise was enough to stabilize the corporate debt market. A risk management focused policy that maybe didn’t quite know which was more important, the price or the quantity, might choose to do both. In that world, the Fed set interest rates at zero along the one, two, etc. year horizons while at the same time expanding the quantity of assets purchased. I think that’s how it would work. At least that what I am thinking tonight.

Bottom Line:  The Fed appears to be taking actions that are not obviously necessary to meet its stated objective of smooth market functioning. It looks like the Fed is trying to enhance the portfolio balance effect of asset purchases. I am not opposed to that, but I am wondering why they don’t just say it. One reason could be that they fear Congress will limit the amount of fiscal support should the Fed push monetary policy further now. I am at a loss for another reason. The implication is that, short-term psychological shift aside, even if the economy just limps ahead it looks like the Fed is providing support for a wide range of asset classes.

Markets Fall, But Don’t Blame Powell

Stocks fell sharply today with the S&P500 losing 5.9% while rates on 10-year Treasuries dropped to 0.67%. It was another one of those unpleasant days that we haven’t seen in a long time. There was some loose talk that the sell-off was triggered by Federal Reserve Chair Jerome Powell’s dour outlook at yesterday’s pressure conference. I don’t find that explanation compelling.

Realistically, Powell said nothing that should have been unexpected. If anything, the Fed’s forecasts as implied by the SEP were arguably optimistic. Returning unemployment to 6.5% in 18 months would not be a terrible outcome given the  rapid jump to double-digit numbers. Moreover, Powell expressed optimism that unemployment rates could return eventually to pre-Covid levels which would imply minimal fundamental damage to the labor market in the long run. And he clearly intends to maintain that outcome as a primary policy goal. No one could possibly have expected Powell to rally around a V-shaped recovery. This was about as good as it gets.

A better story is this:

And this:

The sharp run-up in equity prices in recent weeks was vulnerable to a change in sentiment. The most likely triggers would be a lack of faith that another fiscal support package was on the way or renewed concerns about that pesky Covid-19 pandemic. The latter seems to be driving sentiment today as the virus hotspots appear in previously less-impacted areas. Via the Wall Street Journal:

Some U.S. states that were largely spared during the early days of the Covid-19 pandemic are now seeing record hospitalizations, causing some experts to fear that loosened restrictions and the approach of summer led many Americans to begin letting down their guard.

The post-Memorial Day outbreaks in states come roughly a month after stay-at-home orders were lifted. Experts urged people to continue to take the virus seriously and not take increased freedom as permission to stop wearing masks or resume gathering in large groups.

This is not entirely unexpected but unfortunate none-the-less. Houston is getting ready to pull the trigger on renewed lockdowns. Via Bloomberg:

Houston-area officials are “getting close” to reimposing stay-at-home orders and are prepared to reopen a Covid-19 hospital established but never used at a football stadium as virus cases expand in the fourth-largest U.S. city.

The announcement by Harris County Judge Lina Hidalgo and Houston Mayor Sylvester Turner on Thursday came a day after the Lone Star state recorded its highest one-day tally of new cases since the pandemic emerged.

In my own state of Oregon, via the Oregonian:

Officials at the Oregon Health Authority say they do not know how many contact tracers are working to prevent the spread of coronavirus four weeks after Gov. Kate Brown allowed most counties to reopen.

State officials in April calculated that at least 631 contact tracers would be needed to identify and speak to close contacts of people with identified infections.

The state used that figure to create county-level staffing targets. County officials submitted reopening plans. And Brown on May 15 allowed some counties to move forward despite missing staffing benchmarks, so long as local officials said they could beef up the workforce if needed.

But one month later, as identified daily infections reach an all-time high statewide, the Oregon Health Authority cannot provide basic statistics about how many tracers are currently working.

And we are hiding the data that lets us evaluate the ability to reopen:

The Oregon Health Authority on Wednesday refused to release key statistics used to help justify and monitor Oregon counties allowed to reopen during the coronavirus pandemic.

I suspect we are going to see rolling lockdowns going forward. I don’t think we have to political will to enact another virtually nationwide shutdown, nor can we muster the social responsibility to wear masks or avoid large gatherings. Nor did we have the public health infrastructure in place to adequately contain the virus. What we are going to do is limp along with half measures while a lot of people die.

Likewise, the economic recovery will limp along in this situation. Even a slow simmer of infections will keep the populace wary of leaving their homes and engaging in normal economic activity.

This has really always been the most likely outcome. What will that economy look like? Probably bifurcated, with some segments learning to grow around the virus while other will have a hard time doing so within their existing business models – a lot of leisure and hospitality, for example – and will repeatedly push for a more rapid reopening and be a recurring source for new infections.

The only good news about today’s setback on Wall Street is that every drop in the Dow corresponds to a bigger number in the next fiscal package. In that case, Congress continues to help put a floor under the Main Street, the Fed continues to put a floor under Wall Street, and on net the economy moves forward. Moves forward choppily with unequal outcomes along a suboptimal path, but still forward.

There is a long road still ahead. Still, perhaps there is some room for optimism. Moderna is beginning final testing of a potential vaccine. Others will follow.

Bottom Line: A recovery is coming, but it is not V-shaped.

Powell Is Committed To Reviving Jobs

Federal Reserve Chair Jerome Powell doesn’t care about your worries of a stock market bubble. Nor does he care about your inflation fears. What he cares about is getting people back to work, and he and his colleagues are going to hold rates near zero for as long as it takes to get that result. Learn to accept your low rate future.

As expected, the Fed held policy steady at this week’s Federal Open Market Committee meeting with both rates and the pace of asset purchases left unchanged. Via the Summary of Economic Projections, it also signaled that rates would remain at their current 0-25 basis point range through 2022. Importantly, Powell stressed in his press conference that he and his colleagues were not even thinking about when to raise interest rates. That question is simply off the table.

Indeed, it seems that for Powell, discussion of rate hikes is almost a forbidden topic. He is very clearly trying to not repeat the mistakes of the last cycle in which the Fed repeatedly issued premature predictions that policy would soon need to be tighten, either by winnowing the size of the balance sheet or raising interest rates. Powell doesn’t want to take the risk that a repeat performance would engender expectations among market participants that lead to tighter financial conditions through, for example, a rise in longer-term interests or a stronger dollar that stifles economic activity.

The reason Powell doesn’t want to entertain the notion of rate hikes (‘[w]e’re not even thinking about thinking about raising rates”) is because he has a laser-focus on recovering the jobs lost in the wake of the Covid-19 pandemic. He repeatedly emphasized that returning employment to its pre-Covid level was a primary objective. Powell is also particularly concerned about the employment losses suffered by lower income households, noting that this group didn’t see many of the benefits of the last expansion until the last couple of years when the unemployment rate fell below 4%.

Moreover, while Powell acknowledged that there would be some permanent job losses that require people to change jobs, he thought it too early to conclude that the natural rate of unemployment has risen (the implied estimate of 4.1% in the SEP was unchanged). Powell is not willing to accept that there has been permanent damage to the level of activity and is avoiding the trap of assuming structural change that becomes a self-fulfilling prophecy when the Fed sets tighter policy that anticipates a higher level of sustainable unemployment. In fact, using the example of this past recession Powell was very clear that the he saw little reason to expect low unemployment alone trigger higher inflation.

What this all means is that the Fed’s economic forecast is not that important (Powell said as much in this opening statement). The estimated values of the natural rate of unemployment are also not that important. What is important is actual outcomes.

So what outcomes would drive a policy shift? If the Fed doesn’t see meaningful and sustained improvement in the labor markets as the year progresses, they will likely attempt to boost the pace of growth with more explicit forward guidance and yield curve control. Absent inflationary pressure, they will not tighten policy until the labor market is largely healed. That probably won’t happen until unemployment is below 5%, so a long way off. And Powell won’t tighten policy on fears that the stock market is entering bubble territory. He made very clear the Fed wouldn’t “hold back” on some perception that asset prices were too high. Doing so would not be serving those the Fed was legally obligated to serve by supporting full-employment and stable prices.

That basically leaves only one reason that the Fed might push the Fed into changing policy anytime soon: A sustained rise of inflation above the Fed’s target. But with the economy operating at well above potential and core consumer price inflation negative for three consecutive months running, that seems like a fairly remote change.

Bottom Line: The Fed is making it very clear they aren’t going to budge in a tighter direction until a dramatic change happens in the economy. That seems like a fairly low-probability event at this point. The higher probably event is the threat of an anemic recovery pushes them to an easier policy stance. Rates are once again staying low even if the stock market powers forward. Get used to that divergence.

Keep Your Eye On The Ball

A better than expected labor report supported another leg up for Wall Street as it was the latest piece of evidence that the worst of the downturn is behind us. While that is most likely true, note that there are crosscurrents in the economy that make it difficult to discern yet the extent of the damage wrought by the virus-related shutdowns. We will continue to struggle with the the levels versus differences problem for quite some time. The main trap to avoid is that while the “levels” people will be correct and the economy remains stuck in a sub-par growth path, this observation will probably do little to quell the euphoria on Wall Street.

The employment report surprised massively on the upside as the economy added 2.5 million jobs rather than losing 7.5 million as Wall Street expected. The unemployment rate actually fell, with the U-3 headline number dropping from 14.7% to 13.3% and the broader U-6 number falling from 22.8% to 21.8%. Not great by any measure, but suggestive that we shouldn’t obsess over worse-case scenarios.

The jobs gain appears difficult to reconcile with the ongoing large scale layoffs reported via initial unemployment claims and the still high levels of continuing claims. I think the surprise jobs gains reflects the cross-currents in the economy. One current is the reversal of a portion of the initial job losses from the shutdown. Remember, that part of this recession was unlike previous recessions. We engineered a sudden stop in the economy and it was inevitable that when the economy began to reopen, some jobs, many even, associated with that sudden stop would return quite quickly.

Of course, not all of those jobs will quickly return, or return at all. Any activity dependent on large, densely-packed crowds will need to learn to grow around the virus; that will require some time to accomplish. Some may initially come back as part-time rather than full-time. But many are coming back and can do so quickly.

Against this positive current, however, is an opposing force. The hit to demand triggered more typical-recessionary dynamics. Firms not impacted directly by the initial shock still suffer secondary and tertiary impacts that show up as layoffs or hiring freezes that reduce the uptake of workers. Note that those subsequent impacts are of decreasing magnitude; if they weren’t, any initial shock to demand would drive the economy to zero.

What’s likely happening is that the initial impact is reversing in a big way even as the secondary and tertiary impacts are just getting started. It’s a tug of war in the labor markets and that initial reversal won in May.

That’s good news! And it probably foreshadows other good news such as surging retail sales numbers, for example, in the days ahead. But it doesn’t mean a V-shaped recovery overall is in the making. How these opposing forces sort themselves out won’t become evident until later in the year, probably the fourth quarter. But the ultimate level of the economy later this year is less important for financial markets than just being above the bottom. And that looks likely.

Of course, there are some risks to watch for. We need to avoid the W in the recovery; a set-back does not appear to be priced into equities. One of those risks is the impending fiscal policy cliff when the enhanced unemployment benefits expire at the end of July. Congress can fix that risk easily should they not get overly optimistic about the recovery. It is easy to see that another round of fiscal support to cushion activity as the employment dynamics play out could push stocks to all time highs. It’s also easy to see stocks struggle if Congress waivers on another round of aid.

Another risk is a surge in Covid-19 cases that pushes the economy into lockdown mode. We see cases rising in parts of the nation and there is a concern that the ongoing protests will fuel further spread. In the past I was concerned that further spread of the virus would trigger a fresh lockdown. I hesitate on that now. I don’t think it will be easy to push people back inside again. More likely is that any future responses will be more targeted – see Greg Ip at the Wall Street Journal. We didn’t defeat the virus with the initial lockdowns. Instead we bought some time to learn to live with it. Hopefully we learned enough.

Bottom Line: The economy is bouncing off the bottom and a lot of big numbers are going to be bouncing around with it. It’s going to be like watching the ball in a pinball machine as it jerks from one direction to another. Sometimes its hard to keep your eye on the ball its moving so fast. Wall Street is probably going to be satisfied as long as the ball is moving in generally the right direction, which seems the most likely outcome and even more likely if fiscal policy is not abandoned quite yet.

More Self-Inflicted Risks Than We Need

I don’t know what to tell you. Seriously. Our government just seems to want to inject additional risk into an already troubled situation.

In some ways, it’s all straightforward. We deliberately brought the economy to a stand-still. We got behind the curve on the Covid-19 virus and really didn’t have much of a choice but to shut it all down. The immediate outcomes were fairly predictable. Employment dropped sharply and household spending plummeted. We know the former already via initial jobless claims and employment reports and we get another round of negative news on that front this Friday. Last week we saw how deeply spending plummeted in April. Not pretty:

Still, not unexpected. The entire point of the shutdowns was to choke off activity by keeping people at home. And there was something of a plan to deal with the economic fallout, albeit a bit of a haphazard plan. That plan too was in some ways simple: Pump income into households via a variety of mechanisms to, in simple terms, keep the money flowing in the economy. And that too was successful, at least at a macro-level. Transfers more than compensated for lost wages and salaries:

What happens when you drop a slug of money on the economy that can’t be spent? The savings rate surges:

Again, this is at a macro-level; at a micro-level, the unequal and slow distribution of money, particularly as associated with unemployment insurance, has left many struggling to bridge a gap in their finances. That said, many will receive benefits in excess of their incomes. It’s not a perfect plan in any sense, but not the worst especially considering how quickly it was implemented.

As we begin to see a reawakening of the economy, activity will jump higher. Not jump back to February, but it will bounce. Some sectors will some back quickly; I expect health care employment, for instance, to regain jobs quickly as elective procedures return. You can even see the bottoming-out of the economy starting to form in the ISM manufacturing numbers:

Of course, while the initial phase of the recovery may feel a bit thrilling, the recovery will most like lose speed soon thereafter. Too much of the economy will continue to be suppressed to some degree to allow for a fuel recovery. Moreover, firms that went out of business during the shut downs by definition won’t be restarting quickly.

Consequently, the economy will continue to need federal support to transition into whatever the post-Covid economy looks like. It is imperative to keep the money flowing to households during the transition. The Republicans, however, are trying to back away from fiscal support sooner than later and look to be trying to limit the size of the next package to something under $1 trillion. Senate Majority Leader Mitch McConnell is also claiming it will be the last bill. I continue to believe (hope?) that this is more posturing than anything else. I would think the Republicans have enough problems heading into the fall that they wouldn’t want to rip the rug out from under the economy. Something bigger than McConnell’s current position seems likely.

Sadly, even the Democrats are beginning to line up with the deficit hawks as a bipartisan group of House members already looks to curtail the national debt. There is no need for this. It sets up expectations that the government will more likely than not allow only a partial recovery of the economy. There is no reason to have this discussion before the economy has regained its footing. It’s simply counterproductive.

Oddly, I would like this to be the last major federal support package because I would prefer that it be open-ended with provisions that phase out support as the economy improves. What we will likely get instead is package that limps along the economy enough to keep the deficit hawks claiming there is no need for more. Enough to keep the economy growing yet it becomes a fight to get more down the road. It’s the kind of fiscal outlook consistent with a persistent output gap such as that of the CBO’s new estimate. The CBO predicts it will take a decade before output regains levels of the pre-Covid projections.

OK, so let’s just assume that we get another blast of fiscal support. It won’t be a $3 trillion bill, but it will probably be more than a $1 trillion. At the same time, the Fed is keeping the pedal to the metal with low interest rates, asset purchases, lending programs, and increasingly clear guidance that policy rates will be zero for a long time. Overall, a generally supportive set up for financial markets in the near term. Not great, but good.

Problem is that this story feels more vulnerable this week. The rise of unrest across the nation, and the lack of leadership to quell that unrest leaves a big question mark over the outlook. The best-case scenario is that the riots soon revert back to continuous, massive, but peaceful protests. The worse-case scenario is that President Donald Trump acts on his threat to use military force to end the riots.

I would prefer not to think about such possibilities, yet here we are. Aside from the obvious additional damage to the nation’s social fabric, widespread use of military force domestically would I suspect inflame the situation further, worsen consumer activity, and slow the progress of recovery. In addition, it would intensify partisanship in Congress and delay the next fiscal support bill. Moreover, the large crowds and the shutting down of testing facilities also raise the question of a surge in Covid-19 cases in the weeks ahead; if the virus gained another foothold, we would find cities and states forced to retreat on plans to reopen.

Needless to say, widespread military action against U.S. citizens coupled with a resurgence in Covid-19 cases would be … bad. The psychology could turn against equities quickly, just as it did in March.

Bottom Line: On a certain level this shouldn’t be that hard, at least from a macro-policy perspective. Keep pumping money into the economy to support incomes as you build out the public health infrastructure to contain the virus while gradually ramping back up the economy. We just can’t fully commit to that program. That lack of commitment leaves us with a few more downside risks than I would like.