The Monetary and Fiscal Put

A long week comes to an end with risk assets having a very strong run, the VP debate in the books, another round of long end Treasury supply behind us and a continued focus on fiscal discussions in DC. For now, markets appear somewhat immune to the timing of more fiscal relief ahead of earnings season. Bigger picture, cash flow is still critical here on multiple levels as we continue to deal with the virus and reopening dynamics globally

Let's take a look: 

Markets remain in risk-on mode as we move closer to the 2020 election. In the end, quality real yield is still hard to find and the message from global central banks remains clear: rates low for a long time. We've seen this show before and its impact on risk-assets over time. 

Market price action:

1) Democrats sweep: more, bigger, faster liquidity and spending

2) Republicans sweep: less, but still more liquidity and spending

3) Trump, Congress the same: slower, but more liquidity and spending

4) No fiscal aid: The Fed expands the balance sheet (Fed minutes)

60 Seconds

The markets appear immune to fiscal timing. It's inevitable we get more liquidity and true stimulus at some point. What is not immune to timing: unemployed individuals and small and medium size businesses struggling with reopening or shut for good. But this is where the Fed comes into play should the damage accelerate into 2021

THE PUT OF ALL PUTS

In many ways, markets are embracing the "put of all puts". We've known for decades the notion of the "Fed put". And what we are seeing now is the "put of all puts": The notion that not only will the Fed support markets for years to come, but the notion of trillions more in fiscal liquidity and ultimately stimulus a near certainty. We are not advocating more debt, but resigned to the fact within this period of history extraordinary amounts of "spending" will be necessary to salvage our domestic economy. 

Money Zero Maturity versus Total Outstanding Treasury Debt

There is little doubt where the Fed stands on more fiscal support . And we've deemed it unchartered, consistent and coordinated. The markets have never seen a Fed so unified when speaking on fiscal policy. But as the Chairman indicated in his speech this week: "the Fed will let history judge the crossing of Red lines. Now is not the time".   

POWELL AT THE NABE

Chairman Powell spoke specifically from the NABE this week. The released text from Powell Tuesday: 

https://www.federalreserve.gov/newsevents/speech/powell20201006a.htm

We continue to find the Chairman consistent in his message. The Fed is going nowhere, anytime fast until three criteria are met: 

1) Labor market is consistent with maximum employment

2) Inflation reaches their 2% target

3) And on course to moderately overshoot 2%

This week the Chairman referred to their guidance as strong and outcome based. Yet, at the same time there is a fair amount of discretion within those three parameters and outcomes. And in particular maximum employment which the Fed has indicated includes variables outside of monetary policy and unwilling to assign a number to. 

A few Powell highlights from the NABE:  

1) Still stressing with force the need for more fiscal support. The Fed views this as a shock to the system, and not a move around moral hazard behavior. That's a clear and important distinction from 2008. Powell acknowledged the unsustainable nature of our budget deficits relative to growth. But continues to stress the timing in which to address: now is not the time. 

2) Risk in doing too little, not too much. And time matters. The underlying economy was in a very strong place before the pandemic. To that extent, the quicker and more forceful the reaction (monetary, fiscal and health), the greater the likelihood we salvage long term damage.

3) Not the time to worry about Red lines. We penned a white paper on this earlier in the year. No regrets on the secondary and primary credit programs and inclined to let history judge their successes. Hard to argue with that given the lack of balance sheet utilized versus the primary issuance in the market this year. In many cases we are now seeing big corporates restructure their balance sheet given the all-in level of funding levels with Treasuries rates so low. 

4) Both sides of the Fed's mandate matter. We've discussed the lean on the inflation side in early 2019. We now see the same potential on the employment side, especially with the damage from the pandemic. the Fed still retains a fair amount of flexibility with their guidance from the September meeting. 

 5) Fed concerned about temporary job losses moving to permanent. We highlighted this last week with the job's report and Powell specifically mentioned this trend today. Consistent with the Fed's call for more targeted fiscal aid and sooner than later. 

6) Negative rates: consistent. Not being considered or in the Fed's tool kit. The practical evidence of success is limited and the Fed is comfortable with the existing tools to achieve its dual mandate. We've written extensively over the course of 2020. 

7) Fed continues to link the success in the economy to the virus: the following of recommended social protocols. This is nothing new from Powell or the Fed. 

THIS WEEK'S FED MINUTES AND NY FED PRESIDENT WILLIAMS

We didn't extrapolate much new from either Williams' speech or the Fed Minutes.

https://www.federalreserve.gov/newsevents/pressreleases/monetary20201007a.htm

https://www.newyorkfed.org/newsevents/speeches/2020/wil201007

We do highlight a few key points from the Fed Minutes: 

Balance Sheet

Fed: "Some participants also noted that in future meetings it would be appropriate to further assess and communicate how the Committee’s asset purchase program could best support the achievement of the Committee’s maximum employment and price-stability goals"

 AVI: By now the market is fully apprised of the Fed's intention with rate policy: on hold through at least 2023 with conditions around meeting maximum employment, 2% inflation and a trajectory to exceed its inflation target for "some time". In the end though, the market loves balance sheet expansion. In many ways perplexing since much of the money created fails to reach the real economy. 

It is certainly plausible the Fed changes their asset purchases at some point. This could be same size, more focus on the long end or simply large scale asset purchases (long end). It doesn't sound like we are quite there. Perhaps more importantly is the efficacy of further purchases with rates already at all-time lows. In the end, and as we've been discussing, more asset purchases right now does little to help those unemployed by the pandemic, nor businesses shut or struggling as we continue to work through the pandemic. Cash is still king and this clearly points to more spending from the fiscal side. 

Forward Guidance

Fed: "Participants generally noted that outcome-based forward guidance for the federal funds rate of this type was not an unconditional commitment to a particular path. Indeed, outcome-based guidance of this type would allow the public to infer changes in the Committee’s assessment of how long the target range for the federal funds rate would remain at its current setting. Information pointing to a weaker outlook for the economy and inflation would tend to lead to public expectations for a longer period at the current setting of the target range while information suggesting a stronger outlook for the economy and inflation would tend to lead to expectations for a shorter period at the current setting. In addition, circumstances could arise in which the Committee judged that it would be appropriate to change its guidance, particularly if risks emerged that could impede the attainment of its economic objectives

AVI: Some in the market construed this excerpt from the minutes to be slightly hawkish. In many ways, though, it seems intuitive. The Fed has told the market what to watch. And certainly based on the most recent SEP, we have an implied timetable for rate policy. But clearly circumstances can shift, and in both directions. Even within the Fed's forward guidance, a great deal of flexibility exists especially around the assessment of maximum employment. We expect the Fed to maintain flexibility going forward as it still remains too early for more definitive parameters. In reality, the global economy is still very challenged with clear risk factors going forward. And certainly one of the risk factors to the Fed's forecasts is the evolution of more fiscal aid. Bottom line in our view: The Fed has no crystal ball here. No one does for that matter with the pandemic. They've laid out guidance and sent a strong message with regards to how the individual committee members see the path of the economy and rates with no guarantee things can't change in either direction. 

FISCAL NEGOTIATIONS

The fiscal negotiations have left much to be desired. One way or another, markets are counting on some form of more liquidity. In the end, the inconsistencies in communication from all of the stakeholders has been abundant. Honestly, bizarre at times from both parties. We are in one of the most consequential, unpredictable political seasons in recent time with a pandemic. The masses appear far more anxious than markets. 

The dynamics of how this fiscal deal gets done is still perplexing to us. On one hand, the SOTH urged the airlines to hold on. In the next breath yesterday, the Speaker is open to rolling over terms for the airlines from the CARES Act, but "no small deal without a big deal". What does that mean exactly? What about the leftover PPP money over $100 billion from the original CA? 

On the Republican end, it's not at all clear the Senate will support a broader deal, and even a few senators are objecting to just more money for the airlines without taxpayer protection. With that, the President's improved offer of roughly $1.5T would appear to lack support from the Senate Republicans. 

So: if the SOT Mnuchin, the SOH Pelosi and the Potus agree to a broader deal worth X trillion, do they have the votes in the Senate to pass it? It sounds unlikely. 

We've discussed, short term markets are performing with the notion that more liquidity, and ultimately stimulus, is a near certainty. And seemingly not bothered by a longer time frame for that to happen. Although this week's claims numbers continue to show improvement in certain aspects, the pace of improvement similar to the recent jobs report, has slowed. That's just a fact. And to the Fed's point of linking continued improvement in the economy to the virus, merit exists. Our view: time matters here. Fed's view: time matters here. But this market has been no stranger to disconnect between the real economy and performance. 

Short term, the Fed has thrown their hands up (for the most part). Yesterday we heard from both Boston and Dallas Fed Presidents: Rosengren and Kaplan. And the message is very clear: financial conditions are loose, further asset purchases should be considered but would likely have a limited affect and the lack of more timely fiscal support will be costly as the rebound slows. "Tragic" is actually the word Rosengren used specifically in referring to the lack of more fiscal support. 

In the end, and very practically, the Fed cannot replace cashflow for both individuals and businesses. And this notion of lending, not spending. Even the lending programs with the Fed have struggled. The money from asset purchases winds up in the banks, and not necessarily into the hands directly of those in need right now. This is the job of the Federal government right now. 

Bank Reserves versus Fed Balance Sheet

DALLAS FED PRESIDENT KAPLAN OVERNIGHT

Last night, Dallas Fed President Kaplan spoke on Bloomberg Asia. We find him to be one of the more practical and astute committee members. A businessman. Dissenter.

Kaplan hit on a few topics that we've been discussing this week coming out of the Fed Minutes (see our summary above).

Kaplan: Balance Sheet

We've been very vocal about the inability of further asset purchases to impact the real economy at this stage. And this is what we heard specifically from Kaplan yesterday: "hesitant for further purchases beyond what the Fed is already doing, with larger Fed balance sheet expansion only likely to benefit financial markets".

True. 

Recently, there has been a chorus within the Fed showing concerns about moral hazard and excessive risk taking off the back of loose monetary policy. In fact, Boston Fed President Rosengren said specifically yesterday this current downturn will be worse because of the "risk buildup" over the past decade with monetary policy highly accommodative. It is no secret the impact low rates have on asset and deal valuations. Just look at the pickup in M&A activity. Commercial real estate valuations, and so on. 

Kaplan: Forward Guidance

We wrote this week about the excerpt from the Fed Minutes about the Fed's forward guidance "not being an unconditional commitment". Kaplan was clear in his answer: the Fed's been clear about zero rates over the next several years: It's beyond that where the flexibility comes in. The Fed has no crystal ball here. And at some point conditions may warrant a shift in course. Seems logical and prudent, but with likely little significance for the next few years. Right now, if anything, the risks are skewed to overdoing it (Fed). Powell was clear this week in speaking about more fiscal support: asymmetric with the greater risk of doing too little. 

Kaplan: 13(3) Programs

Kaplan spoke last night specifically to the Main Street lending facility. And he described a scenario whereas banks are reluctant to own 5% of loans that are undesirable (Main Street), while looking to own 100% of loans they underwrite independently. In the end, banks are accountable to their shareholders: plain and simple. In general, the latest Fed balance sheet numbers from yesterday show a slow grind higher with continued asset purchases being slightly offset with central bank swap lines rolling off. The Main Street lending changes were positive but very small and now amount $40 billion on the balance sheet including $37.5 billion in capital from the Treasury Department. The Fed's balance sheet currently sits at $7.075 trillion.  

US LONG END RATES

For the first time in a while, US rates showed signs of life this week. The direction really secondary to the market actually moving. In general, and from our weekly last Friday, we favored the notion of "slightly" higher rates with the continued hope of more fiscal support in conjunction with long end Treasury supply this week. The last two long end auction cycles have commanded concessions, but within the confines of a multi-month range since the extreme Fed driven moves from March. 

This week we broke the 10-year Treasury yield down into channels and buckets from the past 2 years (Powell, tariffs, Pivot, curve inversion, Covid, Fed bazooka). 

First channel (downward): Fed tightening cycle peak 2018. Fed and global central bank Pivot 2019: mid-cycle.

Second Channel (sideways): Summer 2019. Tariff grab. 30-years make all-time lows August 2019 (back then). Negative asset pool hits all-time high (1.50-2%)

Third channel: Covid hits US early 2020 (1.50% break), March bazooka and USD funding squeeze. Vertical down.

Fourth channel: Sideways, steady monthly Fed buying, uneven economic reopening around Covid (50-90 basis points).

We are still well within the multi-month range if we exclude the March "position", USD funding move which took us to 1.20% with massive Treasury liquidation. 

For a great deal of time over the past 2 years, US Treasuries have performed as a strong hedge against risk assets and geopolitical risks. And over the most recent sideways pocket of time, that inverse relationship has broken down with volatility in the Treasury market dominated by continued Fed purchases and intervention. And the extreme forward guidance being offered through short term interest rates. In the end, a good portion of new issuance in the Treasury market absorbed by the Fed's balance sheet. 

WEEKLY SUMMARY

We have reached a very dynamic point in this economic rebound. The economic numbers are clearly slowing, the virus still nagging the reopening and individuals and businesses concerned as we head into the Fall and Winter months. With rates at zero, much capital appreciation realized in risk assets since March, we are seeing a reach for scale and pickup in M&A activity.

The Fed's limitations at this stage of the rebound are clear. And to their credit, they've been very vocal about it. Yesterday's continuing claims numbers were encouraging, but still 3.5 million higher than the PEAK of the 2008 crisis. Context. We still believe it will be the employment side of the Fed's mandate that will be the biggest motivator of more Fed intervention going forward heading into 2021. 

Continuing Claims (2000-2020)

The election and fiscal side of the equation remains paramount here. And although we have leaned slightly bearish in rates, it's been solely within the context of the broader six month range of 50-90 basis points in 10-years. And with the notion of recent supply concessions for long end supply.

We still see enough event risk at this point to keep all markets on their toes. If the first 282 days of 2020 are indicative, there are sure to be more surprises with twists and turns over the next 25. For markets at this juncture, the Fed has and will be a rock and the likelihood of more support from Congress is high, albeit with uncertain timing. For now, that uncertain timing appears moot to risk assets. 

Have a great long weekend!