After the severe economic shock from COVID-19, market sentiment rebounded from the March 2020 lows when credit spreads widened dramatically. The extraordinary monetary and fiscal response from the Federal Reserve and Congress helped stabilize the markets.
During 2Q2020, states began to ease their lockdown restrictions in May so that all 50 states re-opened at varying levels of economic activity. The economic data which was expected to be dire for a long time started indicating that there might be a V-shaped recovery. Unfortunately, in June civil and social unrest, surges in positive COVID-19 cases, and rollbacks of some of the re-openings has added uncertainty regarding the length of the recovery. Fixed income markets reacted mildly due to their reliance on the Fed’s steadfast statements that the Fed and Treasury will do whatever it takes to stabilize or backstop the markets.
Federal Reserve Support
The Federal Reserve announced and began executing substantial open-market policies to help restore confidence and liquidity in financial markets. The Fed continued buying $80 billion Treasuries and $40 billion net agency MBS monthly Rates in the front-end remained near zero, as the Fed continues its zero Federal Funds rate policy.
The Fed unveiled new programs, modified existing ones and started buying corporate bonds consistent with their pledge to support markets and the economy. On April 9, 2020 the Federal Reserve announced several new lending programs totaling $2.3 trillion. The new programs include a $600 billion "Main Street" lending program for small-medium sized businesses to support workers on the payroll.
The Primary and Secondary Market Corporate Credit Facilities helped support corporate bonds. It began purchasing ETFs and corporate bonds. The announcement of the Term Asset-Backed Securities Loan Facility supported ABS.
The Fed has expanded its balance sheet by about $3 trillion since March and will make unlimited asset purchases to support market functionality and financial conditions. The numerous lending facilities announced in March still have plenty of capacity to be used. Very little has actually been spent by the Fed under many of these facilities.
On the fiscal side, the U.S. government passed the Coronavirus Aid, Relief, and Economic Security Act (CARES) in March, a $2.3 trillion stimulus package worth approximately 10% of GDP.
As expected, the June 2020 Federal Open Market Committee (FOMC) left its target rate range unchanged at 0.00% to 0.25%. The Fed announced that it would not consider negative interest rates. The Fed made no changes to its forward guidance, Summary of Economic Projections (SEP), with projections showing no rate hikes through 2022. Fed Chair Powell stated in a press conference during the quarter that negative interest rate policies (NIRP) were not under consideration as their experience shows that the policy has not helped stimulate growth in Europe and Japan.
Negative rates adversely impact bank profits, and their ability to lend. The Fed has more effective tools in the form of its credit facilities and other liquidity support programs. Negative rates represent operational challenges for banks, money market funds and the Fed.
The US economy plunged into a recession in March with Q1 GDP declining 5%, Q2 is expected to drop 35% before rebounding 12% in the second half of the year. The median GDP projection was -6.5% for 2020, +5.0% for 2021, and +3.5% for 2022.
During 2Q2020 unemployment claims reached 40 million due to the COVID-19 shutdowns. The CARES Act (Paycheck Protection Program) was designed to save jobs and prevent layoffs. Instead large companies elected to layoff employees to preserve cash.
There were impressive jobs gains of 2.7 million in May and 4.8 million in June that surprised investors. Non-Farm payrolls gained 4.8 million jobs in June which was higher than the expected 2.9 million.
The unemployment rate peaked at 14.7% in April and has since come down to 11.1% in June. The tilt was toward lower-pay jobs so average hourly wages declined.
The ISM manufacturing index rose to 52.6 in June. Higher than 50 indicates an expansion in manufacturing.
Money Market Funds
In April, over $450 billion flowed into money fund assets reaching an all-time high of $5.04 trillion on April 30. With lower market volatility and stabilizing net asset values (NAVs), money flowed back into prime and muni funds in April. The prime sector had 4 consecutive weeks of inflows in April totaling $82 billion. Muni funds had $6 billion of inflows in April.
Prime money market funds started growing due to the yield advantage over government and Treasury as investors grew confident that the possibility of fees and gates being instituted seemed more unlikely with the Fed’s Money Market Liquidity Facility in place.
Inflows to Prime money market funds started in April and reached over $1.1 trillion in assets by quarter-end. In the meantime, government money market funds continued to grow to over $5 trillion in assets by quarter-end.
The increased Prime fund assets further increased demand for money market instruments such as commercial paper. In contrast, commercial paper outstanding dropped by roughly $39 billion in June in addition to $40 billion drop in May as corporate issuers termed out liabilities to capture low rates in long-term markets. Yields in money market securities continued to compress.
LIBOR rates plummeted as spreads tightened since March due to the extraordinary liquidity introduced by the Fed and government support facilities. One-month LIBOR rates were crushed from 1.09% to 0.16% and three-month LIBOR decreased from 1.45% to 0.30%.
Bank Financial Soundness
The results of the Federal Reserve's annual stress test (DFAST) on the U.S. banking system were released in July 2020 in addition to the annual CCAR. The stress scenario was based on current economic conditions and assuming a V-shaped economic recovery in 2020. The Fed reported that all of the banks performed well under that scenario. The banks have been building capital for the last few years which enables the banking system to absorb potential losses and remain well capitalized. The Fed also included a sensitivity analysis that included the potential impact of the COVID-19 pandemic on multiple economic conditions. The analysis included assumptions for a U-shaped and W-shaped economic recovery. Under these scenarios, 25% of the banks would have Common Equity Tier I ratios of 5.5% or less in a U-shaped recovery. 25% of the banks would have Common Equity Tier I ratios of 4.8% or less in a W-shaped recover. The minimum level is 4.5%. Given these narrow margins, the Fed announced several requirements to ensure that the system remains strong should there be a U- or W-shaped recovery that include:
Share repurchases for Q3 2020 are to stop except for employee stock ownership plans.
Dividends are capped at Q2 2020 levels and future dividends are limited to the trailing four calendar quarters average net income.
Scheduled payments on preferred equity and subordinated debt are permitted, although redemption of Tier I instruments in Q3 2020 is prohibited.
A Stressed Capital Buffer will be integrated into the CCAR process in 4Q2020. The Board will provide updated scenarios to banks and banks are required to resubmit capital plans within 45 days to be reassessed by the Fed. The Fed has discretion to continue to restrict dividends on a quarterly basis.
The Treasury has issued nearly $2.5 trillion in additional T-bills since it began funding its COVID-19 related outflows in late March. The Treasury cash balance has grown to $1.6 trillion in late June from $400 billion in March.
There may be net decreases in T-bill supply in July because tax filings and payments on July 15 result in large cash receipts by the Treasury. The Treasury issued large amounts of T-bills to raise cash during the COVID-19 turbulence, it will now begin to term out the new debt. The Treasury will gradually reduce the T-bill share of the total debt outstanding.
The Treasury re-opened the 20-year Treasury Bill as part of its quarterly refunding. This will term out some of its liabilities in order to fund the government’s fiscal rescue package. This is part of the $3 trillion worth of borrowing in May. The national debt is around $25 trillion.