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Macro outlook

Fed determined to save U.S. economy … if it can

Brian Nick
Chief Investment Strategist
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Over the past six weeks, the Fed has relaunched virtually all of its emergency liquidity programs used during the global financial crisis and started several more, all in the name of keeping the financial system functioning and helping the U.S. economy recover once the global economic shutdown is over. It used its April meeting as a status update for how its efforts have worked thus far. 

Brian Nick video thumbnail discussing the Fed’s latest statements 

What happened?

The Federal Reserve’s Open Market Committee (FOMC) held its April meeting as scheduled after surprising markets back in March by releasing its previous statement three days early. To no one’s surprise, it maintained its policy rate range close to the zero bound (0.00% − 0.25%) and plans to continue a wide variety of asset purchase programs to provide liquidity to financial markets.

Notably, the Fed’s statement did not provide guidance on how long it expects to keep rates anchored at zero. However, it did add a new sentence describing the health care crisis posing risks to the economic outlook over the “medium term,” which is typically seen as a period of one to two years. This hints strongly that the Fed does not believe its job will be over if and when the economy re-opens.

In comments to the press after the meeting, Chair Jerome Powell expressed the view that rates would be at or near zero “for a good while” and continued to emphasize his belief that the Fed’s current role is to help keep financial markets functioning and minimize the damage done to the economy during the shutdown. He also made clear that expansive fiscal policy – which must pass through Congress and be signed by the president – will be the most effective way to fill the economic hole.

While we were away…

As it turned out, the title of our last FOMC reaction piece, The lender of last resort’s last resort, sold the Fed short. We have seen a litany of programs – old and new – to backstop liquidity across financial markets and to serve as the conduit for direct loans to non-financial businesses for the first time. The Coronavirus Aid, Relief, and Economic Security (CARES) Act, passed through Congress and signed by the president in March, allotted up to $500 billion for the U.S. Treasury to place into special purpose vehicles that are essentially maximum loss allowances for the Fed to lend money and, in many cases, purchase assets directly.

The Fed used these funds to set up corporate bond purchase facilities, including a recent change that allows it to buy high yield corporate bonds packaged into exchange-traded funds. It also launched a municipal lending facility that, while stopping short of buying municipal bonds in the open market, provides aid to states and localities – issuers of municipal bonds – that are having trouble staying liquid with revenues drying up. Just this week, the Fed altered the criteria for that program to make many more cities and counties eligible for aid.

The new Main Street Lending Facility provides money directly to banks who lend to medium-sized businesses affected by the economic shutdown. A similar facility has just been started to allow the Fed to purchase loans made through the Paycheck Protection Program, a CARES Act program intended to help small businesses. While neither of these new functions entails having the Fed lend directly to nonfinancial businesses, the central bank – and by extension the U.S. Treasury and taxpayer – is assuming the risk associated with the loans.

Those are just the highlights from the Fed over the past few weeks. The “usual” dollar swaps with other central banks have also been put in place – and expanded – as they were in 2008. And the Fed continues to assist with liquidity in short-term money markets as it has in the past.

Is that all there is?

Market observers were watching the April meeting closely for any hints that the Fed intends to do more in the near term to help the financial system and the economy. While the Fed’s statement made no firm commitment along these lines, Powell offered an interesting transition on the rationale for asset purchases. He said that they were intended to ensure smooth market functioning, but could also be seen as easing financial conditions. That likely means asset purchases are here to stay as a policy tool with rates stuck at the zero bound, similar to the QE programs in the years following the global financial crisis.

Nuveen’s expectations from here

While a quick end to the current recession appears likely, as at least some U.S. businesses re-open in the coming months, the strength of that recovery remains in considerable doubt. The biggest wild card is COVID-19 itself. Does it fade over the summer only to return in the fall and wreak havoc on society once more? Or do hasty re-openings in some states cause a spike in new cases and fatalities, strangling the recovery in its crib?

The Fed’s success at communicating a lower-for-longer approach to interest rate policy can be seen in the 10-year U.S. Treasury yield struggling to even reach 0.65%. Following the global financial crisis, the Fed kept rates at its lower bound until late 2015, more than six years after the recession had officially ended. We expect the Fed will be able to hike sometime before 2026, but we are not looking for significantly higher rates at any point along the curve for at least a year.

The Fed typically does not have to consider raising interest rates unless inflation begins to meaningfully accelerate. Despite the historic level of federal deficits being incurred this year, we don’t see prices moving up materially as long as the economy remains in its current hole. Our initial concerns about the coronavirus, which started in Asia, were about its potential impact on supply chains and the potential for it to lead to higher U.S. inflation. Now it is clear that the crisis has been an even more massive demand shock, which will ultimately make it extremely deflationary.

We are also receiving questions from investors about the institution of the Fed itself. Has it crossed some threshold for direct intervention in the economy from which it cannot return? Maybe so. While few would have called the relationship between Powell’s Fed and the Trump administration “cozy” before the crisis, the Treasury and Fed have been working closely – with some success, we think – to help the financial markets and the broader U.S. economy.

The Fed intervened in unprecedented ways in 2008, taking “toxic” debt onto its balance sheet to help encourage financial mergers. It took years for those programs to fully unwind, providing a considerable windfall to the taxpayer. While much of the Fed’s lending during this crisis is short-term, it has undoubtedly expanded the boundaries of its emergency response abilities and, perhaps, its reaction to more routine economic downturns, if those still exist. In doing so, however, it has retained its independence. Indeed, it has arguably been the fastest and most effective entity in the world at addressing the coronavirus’ economic impact.

Investment implications

Our Q2 Outlook provides more details on our assessment of the current investing environment. While nothing resulting from today’s meeting changes our preferences, we have taken a clear “invest with the Fed” approach to asset allocation recently. Markets that have received direct support from the Fed, like the U.S. Treasury and corporate bond markets – including high yield bonds – have performed well in April.

Given the uncertainty about the length and depth of the economic downturn, we know companies will be under considerable stress, and default risk is unusually high. The Fed’s backstopping of bond markets has begun to shrink the illiquidity premium in certain sectors, but our portfolio managers continue to find opportunities in higher rated corporate and municipal markets, where yields are out of sync with fundamentals.

Investors with a longer time horizon positioning for a recovery and willing to accept further near-term losses can also consider moving into high yield corporate and municipal bonds, taking care to use active management and avoid the distressed energy sector, if possible.
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Federal Reserve Statement, April 2020.

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

A basis point is a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%.
The Federal Open Market Committee (FOMC) holds eight regularly scheduled meetings per year to review economic and financial conditions, determine the appropriate stance of monetary policy and assess the risks to its long-run goals of price stability and sustainable economic growth.

A word on risk
This report is for informational and educational purposes only and is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice or analysis. The analysis contained herein is based on the data available at the time of publication and the opinions of Nuveen Research.

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