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The Federal Reserve

The Federal Reserve

The Federal Reserve, once again, is in the public spotlight as the coronavirus pandemic continues. For good reason, as one of their general functions is to promote the stability and smooth functioning of the financial system. For the past few months, the financial system has been anything but stable. Volatility skyrocketed and the market swung 10-12% in each direction as investors reacted to every piece of news, extrapolating long-term impacts, just to reverse the next day.  Many asset classes that used to be champions of liquidity froze as there were far too many sellers and too few buyers. Bonds such has treasuries, short-term corporates, and mortgage-backed securities became increasingly difficult to sell as risk appetites abated and liquidity dried up. In this article, we will explore the themes of the programs that the Fed has created in their attempt to stabilize the markets. The broad themes are liquidity, credit guarantees, and regulatory forbearance.

Liquidity

Liquidity is a major component of a smooth functioning financial system. It instills greater confidence in the price of financial instruments when many buyers and sellers transact at reasonably close prices, quickly, and in large quantities. In the financial world, evidence of liquidity is reflected in the “spread”. To demonstrate spread, consider a stock that you can either buy for $98 or sell for $97, you would be pretty confident of the stock’s value – this would be considered a small spread. Consider another stock that you can buy for $120 or sell for $90, you would be uncertain what the price actually is – this is considered a large spread.

A large spread is a reflection of the underlying risk and/or lack of liquidity. During the height of the market turmoil, most financial instruments were trading at high spreads. Remarkably, even US government treasuries were trading at high spreads. Since high spreads are a reflection of either risk or liquidity issues and that US government treasuries are among the least risky investments, there was mostly a liquidity problem with treasuries.

The Fed stepped in to fix the plumbing of the financial system. The size and scope of the programs cannot be overstated, everything was on the table. The plumbing issues were widespread. The Fed created programs to buy treasuries, mortgage-backed securities, ETFs, and short-term corporate bonds – to name a few. These programs enhance the ability for buyers and sellers to transact in the markets and they promote a smooth functioning market.

Credit Guarantees

To be clear, the Fed itself does not provide credit guarantees. The Fed just facilitates the programs. Should defaults occur, the Treasury Department guarantees to pay back the Fed. Providing credit guarantees is not a new concept, but the breadth of the guarantees certainly is. Short-term dated corporate bonds, known as commercial paper, are usually high quality, liquid bonds. During the height of the panic, liquidity was scarce and there were concerns that the bonds were less likely to pay out. These bonds are included in many portfolios in the form of money market funds. Money market funds usually call them “prime obligations”. Investors quickly sold off their money market funds, but there were fewer buyers of the underlying assets – commercial paper. The Fed created programs to protect both commercial paper and money markets.

Regulatory Forbearance

Banks operate in a heavily regulated industry. After 2008, the regulations became even more strict to prevent a recurrence of a bank-related recession. The stability of banks is essential to a smooth functioning financial system. Activities such as lending, investing, and borrowing grease the gears of the financial system. The Fed is able to take direct action to encourage these activities. Among many other actions, the Fed has temporarily eliminated the amount that banks need to have stored in the “vault” to back deposits, encouraged them to work with mortgage borrowers, and is allowing them to take slightly more risk. This is much different from 2008 where banks entered into a recession with less solid footing. This time around banks are well capitalized prior to entering a recession and have a better ability weather additional risk.

Conclusion

The Fed has taken on a major role in making the financial system more stable. Stability is improved by injecting liquidity into what could otherwise have been an illiquid, non-functioning market. It could be argued that the Fed’s actions create moral hazard, the risk that investors ignore or take more risk knowing they are protected. It could also be argued that the Fed changed from being the traditional lender of last resort to the modern buyer of first resort. In this age where nearly every facet of business is financialized, it is hard to ignore that the Fed’s role has become even more critical. Not to protect the investors, but the well-being of the broader public that invariably relies on a smooth functioning financial system. A system where mortgages and credit is easily obtainable, goods and services are abundant, and trade is free flowing. Therefore, the Fed saw it prudent to not only address liquidity, but to sweeten the deal by creating programs to provide credit guarantees. By temporarily reducing regulation on banks, it allows banks to focus on their primary purpose of extending credit. The market will continue to hold on to every word the Fed makes until the pandemic sufficiently subsides and economic activity resumes.

Important disclosure information

Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.

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