This is the first entry in a three-part series from Madison Investment Fund manager and Madison Business Review contributor Bryce Roth. Check back Friday for the next entry.
History will remember the 16th chair of the Federal Reserve, Jerome Powell, and the current Federal Reserve governors for their rapid and open-ended response to the COVID-19 crisis and the crude oil price war, where Saudi Arabia and Russia are aggressively lowering oil prices. We’re living through the most dynamic economic turmoil since the Great Depression; no playwright could do this dynamic market justice.
The Fed’s response is very much in line with its actions in the Great Recession during 2008 and 2009, which were aimed at creating a wall of money that stops that cycle. This is a look into the Fed’s near history and how it’s responding to COVID-19, caused by the novel coronavirus.
Federal funds rate
The Federal Reserve increased the Federal funds rate, which is the rate banks lend to each other on an overnight basis, from 2010 through Aug. 1, 2019. During that time, the Fed carefully sailed through history’s longest bull market for equities, a protracted trade war first with China and then with other countries, and a drawn-out U.S. government shutdown.
Finally, on Aug. 1, 2019, the Fed cut interest rates by 0.25%, or 25 basis points, to hit a target range of 2-2.25% and spur economic expansion due to trade concerns. Since then, the Fed cut the Federal funds rate by 25 basis points (bps) on Sept. 19 and again on Oct. 31 to maintain the historic bull market expansion.
Then, the COVID-19 virus became a serious threat to the U.S. economy in late February and early March. The Fed started to act aggressively to maintain market liquidity, cutting rates by 50bps on March 3 and a whole percentage point on March 16 to 0-0.25%, a range unvisited since the Great Recession in 2008.
Repurchase (repo) market
In mid-September 2019, turbulence struck the market as repurchase, or repo, rates reached over 9%, according to Trading Economics. The Federal funds rate sets a benchmark for what banks pay to borrow from each other overnight, and the repo market consists of short-term borrowing transactions of government securities between banks, usually on an overnight basis.
A spike in repo rates discouraged these common transactions between financial institutions. The imbalance in liquidity of the repo markets was an early indication of the lack of liquidity that became a crisis in the emergence of the COVID-19 virus. There were three main reasons for the sudden instability.
First, payments for corporate taxes were due on Sept. 15. This led to high redemptions of more than $35 billion in money market funds. In response, cash balances increased by an additional $83 billion in the U.S. Treasury general account, according to PIMCO, an investment management firm. It noted that these reduced excess reserves and at the same time acted to reduce the aggregate supply of overnight liquidity available in funding markets.
Additionally, dealers, people or firms who buy and sell securities for their own account, needed an additional $20 billion in funding to finance the recently scheduled U.S. Treasury issuance, according to PIMCO.
The Fed has had to vastly expand the scope of the repo operations to funnel cash to money markets and is now essentially offering an unlimited amount of money. Before coronavirus turmoil hit the market, the Fed was offering $100 billion in overnight repo and $20 billion in the two-week repo. It has greatly expanded the program since, both in the amounts offered and the length of the loans. It’s offering $1 trillion in the daily overnight repo, $500 billion in one month and $500 billion in the three-month repo markets.
10-year bond rates
On March 3, the Federal Open Market Committee, a committee within the Fed that oversees open market operations, cut rates by 50bps to help insulate concerns for the economy. That action seemed to further concern traders, as the 10-year bond yield continued to decline. The yield on the benchmark U.S. 10-year Treasury touched an all-time low of 0.318% in overnight trading through the weekend before closing at 0.54% on March 9. In 2019, the 10-year note had an average yield of 2.14%.
This yield decline was due to rising concerns of the COVID-19 virus, but it was further exacerbated by failed negotiations in the Organization of the Petroleum Exporting Countries. On March 9, Saudi Arabia and Russia began a price war, which led to a 22.3% decline in crude oil futures. Although this meant lower gasoline prices for consumers, plummeting oil prices are a troubling, negative sign for the market, as falling demand is a tell-tale sign of slowing global growth, according to the U.S. Energy Information Administration.
The Federal Reserve responded by purchasing $170 billion in treasuries and mortgage-backed securities, which supported the 10-year bond yield and positively spurred the market. However, the extent of the economic damage COVID-19 will cause is unclear, so more action may be necessary in the coming months.
Dollar swaps
The Federal Reserve is also beefing up its U.S. dollar liquidity swap line program. Proportionately, the biggest increase in the Fed's balance sheet are dollar swap lines it has with other central banks.
The Fed will now offer transactions of seven-day maturities every day, rather than once a week, starting March 23 and will continue its purchases at least through the end of April 2020. The initial commitment applies to the banks of Canada, England, Japan, the European Central Bank and the Swiss National Bank, which have had standing swap line arrangements with the Fed for years. This facilitation makes it simple for banks to trade their currencies for U.S. dollars when needed. The Fed’s central bank currency swaps totaled $206.1 billion from just $25.2 billion a week prior as of March 27, according to CNBC.
The future
The Federal Reserve is resolute to do whatever it takes to keep liquidity in financial markets. Their success in maintaining any level of stability rests on factors outside of its control. The COVID-19 crisis will roll across the U.S., it’ll also roll across U.S. trading partners.
While China re-gears its production, there’s little demand for products due to economic shutdowns. These are unprecedented times that students will never forget — times that will form our generation and our economic practices throughout life.
Bryce Roth is a sophomore finance major. Contact Bryce at rothbc@dukes.jmu.edu.
