US-Flagge SW

US Federal Reserve caught up in political Furore

US Secretary of the Treasury Steven Mnuchin announced last week that a number of emergency credit facilities would not be extended. This significantly restricts the US Federal Reserve’s room for manoeuvre in the credit markets for the time being.

The next meeting of the Federal Open Market Committee (FOMC) of the US Federal Reserve on 15/16 December will take place in a charged atmosphere. Amid a sharp rise in new cases of coronavirus in the US, the country’s Secretary of the Treasury Steven Mnuchin has decided against extending most of the Fed’s coronavirus emergency credit facilities beyond the end of 2020. He also instructed the Fed to return the unused risk capital from the expiring facilities to the Treasury Department. The financial markets will therefore be without an important safety net from the start of next year, at least until the next US President Joe Biden is inaugurated on 20 January 2021. The Fed publicly criticised the move but did comply with it.

Interest rates to remain low for some time

Union Investment does not expect any surprising decisions to be announced at the next Fed meeting, and certainly not with regard to interest rates. The federal funds rate, which currently stands at 0.0–0.25 per cent, is predicted to remain unchanged until 2023. This is also indicated by the Fed’s own forecasts (dot plot). But the Fed might issue guidance in respect of the bond purchases that it began during the coronavirus crisis, although the volume of purchases will probably not change. The Fed is currently buying at least US$ 80 billion of US Treasuries and at least US$ 40 billion of mortgage-backed securities per month in order to ensure market functionality and favourable funding conditions. Similarly to the third round of quantitative easing (2012), these purchases are to be pegged to economic growth in future and an exit scenario is to be put in place.

At the Fed meeting in early November, most FOMC members were in favour of tapering the bond purchases as soon as permitted by the economic situation and before the maximum employment target and the inflation target are reached. The latter underwent a significant change when the strategy was reviewed in August, although the FOMC continues to aim for an inflation rate of 2 per cent in the long term. Because inflation has been below this target for several years, the Fed will allow inflation to run “moderately above” 2 per cent for a certain period so that inflation averages 2 per cent “over time”. According to the Fed, monetary policy will remain accommodative until these targets are achieved.

The Fed may provide further clarification at its December meeting in order to create greater certainty for market players. After all, Mnuchin’s surprising demand to halt key support measures unsettled the markets. Specifically at stake is the US$ 454 billion fiscal backstop for emergency credit facilities of the Fed. This financial package was drawn up in March and approved by Congress. It gave the Fed the necessary flexibility to support companies and their lenders during the crisis by buying up loans. The central bank was also able to purchase corporate bonds in the primary and secondary markets (Primary and Secondary Market Corporate Credit Facilities), bonds of state and local governments (Municipal Liquidity Facility) and structured credit products based on loans to companies and consumers (Main Street Lending Program and Term Asset-Backed Securities Loan Facility). These five programmes will now have to be terminated at the end of December. Other support programmes, such as in the money market, are not affected.

Return of around US$ 70 billion

Of the US$ 454 billion, however, only around US$ 93 billion was effectively paid to the special-purpose vehicles. And of that sum, the Fed actually only used around US$ 24 billion to secure bond purchases and structured credits. This means that only around US$ 70 billion is likely to have to be returned, showing that the signal sent by these programmes was much greater than their actual relevance to market purchases.

Signal sent by Fed credit facilities much greater than their actual relevance

Signal sent by Fed credit facilities much greater than their actual relevance
Sources: Credit Suisse, Bloomberg, Union Investment, as at 27 November 2020.

However, the move will significantly restrict the central bank’s ability to act in the event of renewed turmoil in the capital markets. This is because further use of these funds will require prior approval from the US Congress. Given the political divisions between the Republicans and Democrats, there is a risk that valuable time will be lost should further problems arise in the markets. Nevertheless, there is a glimmer of hope because the Fed would still have access to the cash in the US Treasury Department’s Exchange Stabilization Fund (ESF). This means that a sum of around US$ 50 billion to US$ 80 billion could be rapidly deployed as a new backstop without obtaining consent from Congress.

Unchanged market outlook

This is probably why the financial markets have so far been laid back in their response to the cancellation of the emergency facilities. Our opinion that the US yield curve will steepen slightly in 2021 has not changed as a result of this. The main factors driving the markets are likely to be further developments in the pandemic, the availability of vaccines and thus the prospect of the economy normalising over the course of next year.

 

As at 30 November 2020