This guest commentary was written on 6/15/20 by Mike O'Rourke of JonesTrading.
It is truly ironic that on the day when the Wall Street Journal Editorial Board publishes a piece titled “The Federal Resurrection Board,” the Federal Reserve updates its term sheet for its Secondary Market Corporate Credit Facility (SMCCF) to even more aggressively purchase corporate bonds that are already well bid.
This is the second such update for the same reasons since the facility was initially announced on March 23rd. According to today’s update to the SMCCF term sheet, “The Facility may purchase individual corporate bonds to create a corporate bond portfolio that is based on a broad, diversified market index of U.S. corporate bonds.”
That implies the purchases will be tied to a specific index. This verbiage differs from that of the New York Fed’s FAQ website that states, “The SMCCF will initially purchase corporate bonds to create a corporate bond portfolio that tracks a broad market index developed for the SMCCF (Broad Market Index). The index will be recalculated at least every 4-5 weeks, and the list of bonds that are eligible for purchase will be refreshed more frequently to add or remove those bonds that newly meet or no longer meet the eligibility requirements. The SMCCF may purchase individual corporate bonds using other methodologies in the future.”
An index developed specifically for the SMCCF places the central bank in the place of picking winners and losers.
Chairman Powell is running the world's largest hedge fund and doing a poor job of it. The historically weak economic environment warrants a very accommodative monetary policy. That said, the Fed’s careless implementation of extreme measures has resulted in over-commitments of capital by the Fed in response to the crisis.
As a result, the Fed has embarked on a massive balance sheet expansion that will not be unwound for years (if ever). The balance sheet expansion that commenced in 2008 and concluded in 2014 was never even close to unwound. The first rule of trading when you are in a big hole is to stop digging. No matter what challenge emerges, Chairman Powell’s only response is to dig further.
Nearly every move appears to be a response to the stock market. Last Wednesday, the Chairman asserted that “Our current policy stance is appropriate.”
He concluded that press conference by stating, “I would say that we're tightly focused on our real economy goals. And -- and again, not -- we're not -- we're not focused on moving asset prices in a particular direction at all. It's just, we want markets to be working and I think partly as a result of what we've done, they are working and -- you know, we hope that continues.” On Thursday, the stock market tumbled 6% and the President, his National Economic Advisor and the Treasury Secretary publicly blamed Powell and the Fed.
On Monday, the Federal Reserve adjusted its corporate bond purchase program to be more activist. What is even more maddening is that this action by the Fed is borderline meaningless.
It serves no monetary purpose and simply puts additional assets on the Fed’s balance sheet that are even harder to unwind than Treasuries, and of course, it disrupts the market's pricing mechanism. The 10 year Corporate BBB/BAA spread over the 10 year Treasury is approximately 180 basis points, which is approximately 20 basis points wider than it was this time last year, a strong economic environment.
The spread is nowhere near the distressed 600 basis points of the financial crisis or even the 340 basis points of March (chart below).
The WSJ’s Editorial Board summarized the situation aptly “But this anomaly of zombie stock rising is cause for concern about how the Fed is distorting price signals and the longer-term economic risks this creates. Capitalism is supposed to be a profit and loss system, but the Fed’s interventions have too often reduced or eliminated the possibility of loss. This may be warranted for now given that government ordered an economic shutdown that has cost companies their revenue. But we’ve learned since the Fed began on this course in 2009 that this can create a financial cycle of Fed intervention and debt that is hard to escape.”
In our view, that nearly inescapable cycle of financial intervention is upon us, and the Fed’s response measures are likely to start failing.
This is a Hedgeye Guest Contributor piece written by Mike O'Rourke, Chief Market Strategist of JonesTrading, where he advises institutional investors on market developments. He publishes "The Closing Print" on a daily basis in which his primary focus is identifying short term catalysts that drive daily trading activity while addressing how they fit into the “big picture.” This piece does not necessarily reflect the opinion of Hedgeye.