Goldman Sachs Asset Management: The Policy Response Shifts into High Gear

Following extreme volatility in financial markets, signs of dysfunction in the bond markets and rising disruptions in US economic activity, the US Federal Reserve (Fed) responded on Sunday with a massive easing program. The Fed’s move, which accompanies a series of steps by central banks and governments around the world, signals that the policy response to the coronavirus outbreak has shifted into high gear.

 

Last week, the US bond market began to experience liquidity issues amid extreme market volatility and recordbreaking declines in equity markets. On March 15, in an effort to increase liquidity and restore confidence, the Federal Reserve announced a massive easing program.

 

The Fed cut interest rates by 100bps, lowering the target range for the federal funds rate to 0.0%-0.25%. In addition, the Fed announced that it would purchase a minimum of $700 billion in bonds, including at least $500 billion in Treasuries and at least $200 billion in mortgage-backed securities. In coordination with other major central banks, the Fed also announced steps to enhance global US dollar liquidity. Finally, the Fed took steps to support bank lending, cutting the rate at which banks can borrow at the Fed’s discount window, eliminating reserve requirements and pledging to support banks “that choose to use their capital and liquidity buffers to lend and undertake other supportive actions in a safe and sound manner.”

 

These policy actions follow recent measures intended to help bond markets function more smoothly, including Thursday’s announcement of $1.5 trillion in repo operations and Friday’s $37 billion in purchases across the US Treasury yield curve. The Fed’s announcement accompanies an ongoing series of steps that central banks and world leaders have taken in recent days to contain the coronavirus and its economic impact, signaling increased coordination and urgency in the global policy response to the crisis. 

 

We think the Fed’s move is important due to the size and scope of the easing measures, as well as the signaling effect of global coordination among major central banks to provide dollar liquidity. Expectations for future Fed easing measures have been growing, and the Fed has likely exceeded expectations for both the timing and size of its next step.

 

By moving now, the Fed has done much of what it can to: 1) reduce the risk that dysfunction in financial markets amplifies the economic impact of the coronavirus; and 2) improve the transmission of lower interest rates to the economy through the mortgage market and bank lending. Markets may remain volatile as there is still tremendous uncertainty around the outlook for economic growth, but we believe the Fed’s actions will help to improve liquidity in the bond market, which had emerged as another risk for investors.

 

The MBS market is one area we will be watching closely to gauge the effectiveness of the Fed’s move. US mortgage rates have been rising recently, despite the sharp decline in government bond yields, reflecting the liquidity challenges in the bond market. We will also be monitoring investor demand for short-term, high quality credit. Last week, we saw bonds issued by banks with strong credit ratings and less than one year to maturity trading at extreme levels, another indicator of liquidity challenges in the bond market.

 

We expect investors to continue to rebalance their portfolios by selling fixed income assets to purchase equities as they seek to generate better returns over time. This rebalancing has added supply pressure in fixed income and has contributed to the liquidity challenges in the bond market, which we expect to eventually be resolved through Fed asset purchases and equity market stabilization.

 

Fiscal policy developments will also be important as monetary policy cannot address many of the challenges posed by the coronavirus outbreak. In the US, President Trump has declared a state of emergency, opening up the availability of fiscal resources and the House passed a bipartisan emergency funding bill with measures to support testing for the coronavirus, pay for sick leave and unemployment insurance. While negotiations on the final bill continue, the Fed’s actions help to buy time. Governments in Europe and Japan are also becoming increasingly aggressive in their fiscal response, with German Chancellor Merkel pledging that the government would do “whatever is necessary.”

 

While the fiscal response is ramping up, uncertainty about the potential economic impact of the virus remains high. We expect volatility to continue until the economic outlook becomes clearer, and we are taking a patient and clinical approach when evaluating the potential opportunities created by broad declines across asset classes.

 
 
 
General Disclosures