As more and more parts of the U.S. economy are impacted by unprecedented social distancing mandates, the Federal Open Market Committee (FOMC) took further action to inject liquidity into the financial systems.
In the second emergency meeting by the FOMC in the past two weeks, the Fed cut interest rates by 100 basis points to between 0.00-0.25%, levels not seen since October of 2015. In addition, the FOMC said it would increase bond holdings of Treasury and mortgage backed securities by at least $700 billion. The FOMC did not provide a time table for the purchases, other than that it would begin purchasing securities immediately. The Fed also said it was reducing the reserve requirement ratio (cash ratio) for banks to zero percent. The Reserve requirement is the amount of physical cash held by a bank plus holdings a bank has at the Central Bank (Fed). Previous to today’s action, U.S. banks were required to hold between 3-10% of deposits in cash or with the Central Bank (the percentage depended on the size of the bank’s deposits).
The fact that the Fed took action just a few days ahead of its regularly scheduled meeting speaks to the urgency of the situation that the markets have quickly found themselves in. The actions taken by the Fed are to try and help improve liquidity in the market. Over the past several days, liquidity across the bond market has declined. Even liquidity in the Treasury market, which is considered the most liquid financial instrument in the world, had declined. While we expect these actions to help improve liquidity in Treasuries, we expect liquidity in the corporate and municipal bond markets to remain challenged which is creating some opportunities.
The short-term funding markets (commercial paper market) that large corporations rely on for funding short-term cash needs is seeing borrowing rates spike as investor fear grows. The strains in the commercial paper market are causing companies to tap credit lines that are held for emergency purposes. We believe that if this fear by the markets continues to increase, the Fed will need to step in and begin buying commercial paper and corporate bonds to help calm the markets. This would be an unprecedented step by the Fed, but one that has already taken place by other Central Banks across the globe.
In response to the move by the Fed, equities appear to be in for additional volatility as they process new information. The Treasury market is rallying with the 2-year note yield now at 0.27% (down from 0.48% on Friday) and the 10-year note yield falling to 0.66% from 0.98% on Friday. The rate on the one-month T-bill has plunged to 0.06% from 0.26% on Friday. While the FOMC has stated that it does not want interest rates to go negative, it appears that it is a real possibility that the markets may take rates negative. The one-month Treasury bill has traded with a negative interest rate in the past, most recently in September of 2015 when it was -0.03%. We believe that we could breach those levels if investor fear continues to rise.
What should we expect going forward? We expect volatility to remain extremely elevated as the entire world has entered uncharted territory with the coronavirus spreading across the globe. We believe the Fed will take additional action, including steps we have never seen before in the U.S., to help provide additional liquidity to the markets. These actions include the purchase of corporate bonds and additional purchases of Treasury and mortgage backed securities beyond the $700 billion already announced. In addition, further action by the government will likely be necessary. We believe we could see additional help for the consumer and small businesses that are being impacted by containment efforts. We could see additional steps taken by the government in the form of loan forgiveness, interest free loans and the further expansion of unemployment benefits. We are clearly in unprecedented times, which requires unprecedented actions by the Fed and our government as collectively we build a bridge to evidence of containment and an eventual reduction in coronavirus cases so that life, the economy and the markets can begin to return to normal.
As always, please do not hesitate to reach out to your Ancora team with any questions.