In defense of the Fed’s junk bond campaign

Hopefully you saw my comments from this morning about the Fed. That was for subscribers only. So, if not, the gist was that I do not support the Federal Reserve’s foray into the non-investment grade bond universe. It opens up a whole can of worms that we don’t want opened. And what’s done, can’t be undone because it sets a precedent both for future policy and for market expectations.

But, this is a crisis. And I recognize why the Fed has done what it has. So I thought I would flesh out briefly how I see the Fed’s thinking. What precipitated this post was my wife’s question, “what’s going on?” to which I responded, “the Fed is buying junk”. That’s how we roll in the Harrison household, y’all. But having answered that way, I was forced to explain to her what I am now going to explain to you – not in vitriolic, lopsided and unmeasured tones, but cognizant of why what’s happened has happened.

So briefly here…

Making an ass out of u and me

As this crisis has unfolded, I have had a number of (sometimes unwitting) assumptions about the ground rules. But, I think we’re seeing some of those assumptions were poor.

Let me outline them in bullet form to be more brief (in parenthesis is whether the assumption is still operative or not):

• The Federal Reserve’s first line of defense is rate cuts and forward guidance about those cuts. (still operative)
• In past cycles, the Fed has needed more than 500 basis points of cuts to get the kind of response to policy it is looking for. Since it didn’t have 500 to work with this time, it would have to go to zero (spot on)
• When rates go to zero, the Fed has limited choices aka ‘is out of bullets’, largely because it sees itself as a liquidity provider, a market maker. It sees its role as circumscribed because it believes Congress is the legitimate elected body to take aggressive countercyclical action unless the issue is financial stability (bad assumption)
•  In providing liquidity, the Fed would err on the side of protecting its reputation over doing too much when it was on a slippery slope (very poor assumption)

In retrospect, the Fed played its expected role down to the zero bound. But, when things unravelled and push came to shove, the Fed was more aggressive than I anticipated, because it is willing to take the hits to its reputation in order to prevent a Great Depression.

Liquidity versus solvency in a 100-year storm

My assumption had been that the Fed wanted market forces to play out — at least to some degree to allow us to separate out companies that would have been bankrupted by a garden-variety recession. But the approach they have taken signals that they think doing so on the fly is too cumbersome and time-consuming to be effective.

The Fed is telling you that – in this 100-year storm – it cannot reasonably be expected to decide which asset markets contain an overabundance of assets of the imprudent and which mostly contain assets of the unlucky. So, they have decided to provide blanket support because that’s what their mandate to maintain full employment would dictate.

In essence, even though I accuse policymakers of being reactive, the Fed is effectively saying they want to be pro-active, even at the risk of its reputation, because time is of the essence. Jay Powell and company know that the longer the Fed waits to institute asset purchase programs, the greater the likelihood of a Great Depression.

My View

I don’t like any of this. But this is the situation we find ourselves in. There are no good choices here.

Nevertheless, while I can understand the Fed’s decision to protect fallen angels, I see the Fed’s decision to buy high yield ETFs as a step too far. These are risk assets. And the Fed is taking the risk away. Long after the exigencies of the day have passed, these decisions will have lasting consequences.

Moreover, where do you draw the line? Why has the Fed left the leveraged loan market untouched? Aren’t those companies just as innocent as the ones in the high yield ETFs? Don’t tell me it’s the fact that its an ETF that matters here. That’s a fig leaf and you know it.

This is where we are. If the economy deteriorates further, we may get even more from the Fed too. I don’t like it one bit though. I’m just glad I’m not the one forced to make these hard choices.

P.S. – The Fed has announced its programs with these ending words:

All of the facilities mentioned above are established by the Federal Reserve under the authority of Section 13(3) of the Federal Reserve Act, with approval of the Treasury Secretary.

And that hearkens back to how the Fed sees its role, outlined in 2015:

The Federal Reserve Board on Monday approved a final rule specifying its procedures for emergency lending under Section 13(3) of the Federal Reserve Act. Since the passage of the Dodd-Frank Act in 2010, the Board’s authority to engage in emergency lending has been limited to programs and facilities with “broad-based eligibility” that have been established with the approval of the Secretary of the Treasury. The Dodd-Frank Act also prohibits lending to entities that are insolvent and imposes certain other limitations. The rule provides greater clarity regarding the Board’s implementation of these and other statutory requirements.

[…]

“Emergency lending is a critical tool that can be used in times of crisis to help mitigate extraordinary pressures in financial markets that would otherwise have severe adverse consequences for households, businesses, and the U.S. economy,” said Chair Janet L. Yellen.

Have a good weekend and stay safe.