This guest commentary was written on 11/19/20 by Mike O'Rourke of JonesTrading.
The big story today broke after close. Of all the potential tail risk scenarios that could enter market environment, the last one we would have expected was an abrupt termination of the majority of the Federal Reserve’s emergency programs.
With one letter from Treasury Secretary Mnuchin, the Federal Reserve’s only meaningful ammunition of approximately $4 Trillion of buying power that covers a broad range of assets will be ending. That includes the ability to purchase corporate bonds that so excited markets. Secretary Mnuchin’s letter to Chairman Powell today stated:
“With respect to the facilities that used CARES Act funding (PMCCF, SMCCF, MLF, MSLP and TALF), I was personally involved in drafting the relevant part of the legislation and believe the Congressional intent as outlined in Section 4029 was to have the authority to originate new loans or purchase new assets (either directly or indirectly) expire on December 31, 2020. As such I am requesting the Federal Reserve return the unused funds to Treasury. This will allow Congress to reappropriate $455 billion, consisting of $429 billion in excess Treasury funds for Federal Reserve facilities and $26 billion in unused Treasury Direct funds.”
When the CARES Act passed, we noted “When the CARES Act passed on March 27th, there was $454 Billion in capital allocated to Treasury for the Fed to leverage. It was repeated numerous times in the media by Secretary Mnuchin that Treasury would give the Fed capital for $4 Trillion in facilities.”
The Fed’s traditional open market operations are limited to government and government backed securities. During the Global Financial Crisis, the Fed inventively (and under questionable legality) created special purpose vehicles in which Treasury (or in some cases private investor) provided the “first loss” equity that was then levered 10x by the Fed to buy assets and support markets. With legal approval from Congress the Fed followed the same plan this crisis.
Such emergency action by the Fed is permitted by Section 13(3) of the Federal Reserve Act, which lets the central bank do just about anything necessary to save the economy. Dodd Frank post crisis legislation updated the rule so that 13(3) actions need to be approved by the Treasury Secretary.
When people talk about the Federal Reserve running out of ammunition or “firepower” as former NY Fed President Bill Dudley did last month it refers to traditional tools. These emergency tools represent the proverbial loaded bazooka if needed to save markets.
Their abrupt removal is a major negative for markets. It should not be surprising the Federal Reserve and Chairman Powell are opposed to the expiration of these programs. Financial markets are raging, frothy, exuberant and complacent, but the pandemic is at its worst levels and the markets can be fickle. It is understandable the Fed Chairman wants to hang on to his dry powder. When the bubble he fueled bursts, he will need to support those asset prices.
Just two days ago at a speaking engagement Powell stated “when the right time comes, and I don’t think that time is yet or very soon, we will put those tools away.” Although this development is a really bad look for the nation’s financial and economic leadership, we suspect it is tied to trying to turn those funds into fiscal stimulus.
The problem for markets is fiscal stimulus does not have the benefit of 10 to leverage, and nobody like losing their free insurance policy.
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.