U.S. Fixed Income

The impact of the Fed's surprise announcement

The Fed actions reflect the gravity of the current situation. However, the Fed is facing new challenges not seen in prior instances of QE.
March 2020

What did the Fed do?

In a surprise Sunday night announcement prior to Asian markets opening, the Federal Reserve made the following changes to monetary policy:

  • Slashed the Fed Funds rate by 100 basis points bringing the target range to 0.0% to 0.25%.
  • Announced the intention to purchase $700 billion of assets ($500 billion of Treasuries and $200 billion of mortgage backed securities (MBS)).
  • Lowered the interest rate on excess reserves (IOER) to 0.10%.
  • Lowered the primary credit rate by 150 basis points to 0.25%.
  • Increased the tenure banks can borrow at the discount window to 90 days and reduced the reserve requirement for many banks to zero.
  • In addition, in coordination with the BOC, BOE, BOJ, ECB, and SNB, the Fed enhanced U.S. dollar swap line arrangements to provide term liquidity to foreign central banks with U.S. dollar operations.

How did the markets respond?

With a Fed scheduled to meet later in the week (March 17-18), the timing of the announcement surprised markets. Given escalating fears, we believed the Fed needed to not only deliver on growing expectations for action, but exceed them. This move exceeded expectations.

We expected a weak market open this week following growing fears over the weekend and uniform calls for “social distancing.” Even with the significant Fed action, on Sunday night equity futures traded down by the allowable limit (5%) and ETFs tracking the market imply a 10% decline to start the day, oil dipped below $30 and treasury yields moved meaningfully lower (20–30 basis points lower across the curve.)

What additional actions may the Fed consider?

The Fed hopes the significant package announced last evening will provide a floor for financial
markets. While the traditional tools of lowering interest rates and adjusting reserve requirement
are largely deployed there are additional measures the Fed can consider, including:

  • Additional QE: The Fed could increase the size of US Treasury and MBS purchases. For instance, given market growth, a $400 billion increase in mortgages and treasuries would mirror the 2008 and 2010 QE programs. While other central banks have purchased corporate debt (ECB & BOE) and equities (BOJ) these assets are not currently allowed by the Federal Reserve Act and Chairman Powell stated the Fed would not seek congressional approval to broaden its current authority at this time.
  • Targeted liquidity measures: 2008 programs such as funding for commercial paper or money markets could be reinstated. The Fed may also consider a Long Term Refinancing Operations (LTRO) similar to the ECB.
  • Forward guidance: Forward guidance remains a primary tool for the Fed. Indeed, in Chairman Powell’s telephone press conference Sunday night to address the policy action, he noted that rates will stay at zero, “until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”
  • Yield curve control: Several Federal Reserve governors have noted that a program capping yields out to the intermediate sector of the yield curve could be successful in maintaining a positively sloped yield curve at low levels of interest rates.
  • Changes to inflation strategy: The Fed may move to an average inflation targeting regime in an effort to anchor inflation expectations and enhance credibility and commitment to achieving their inflation goal.

What do we see happening?

The Fed actions reflect the gravity of the current situation. However, the Fed is facing new challenges not seen in prior instances of QE. Understaffed trading desks may pose operational challenges and the low levels of starting yields may make it difficult to incentivize investors to move out the risk curve. Additionally, the Fed cannot act alone. While the Fed can promote credit, liquidity and market function, it cannot direct these measures to sectors and businesses facing the most significant pressure. We would hope to see targeted fiscal policy in coming days to address these issues.

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Disclosures

Views and opinions have been arrived at by BMO Global Asset Management. The information, estimates or forecasts provided were obtained from sources reasonably deemed to be reliable but are subject to change at any time. This publication is prepared for general information only; it should not be construed as investment advice or relied upon in making an investment decision. All investments involve risk, including the loss of principal. Past performance is not a guarantee of future results.

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