Unlike Space X, the Fed will not be considering "lift-off" anytime soon. The Fed’s new frontiers will instead remain in the realm of expansionary monetary stimulus. The FOMC indicated yesterday that the next, but perhaps no means final frontier, could be its first foray into "yield curve control".
Yield curve control – the next frontier?
The phrase "yield curve control" was first popularized by the Bank of Japan in 2015. In the US, it would involve the Fed explicitly targeting two to five-year treasury yield levels rather than just setting the overnight interest rate.
The intended effect would be that corporate and household borrowers would also be able to take full advantage of the Fed’s lower interest rate policy. Chairman Powell stated yield curve control remains an “open question” and that discussions would continue at further meetings.
Rates potentially unchanged for three years
In the first "dot-plot" release this year (after March’s release was abandoned due to the crisis), FOMC members forecasted no change to interest rates until 2022 – a stark reminder that the economic legacy of COVID-19 could even outlast the virus itself.
A floor and no ceiling on asset purchases
The Fed also committed to maintaining its Treasury and agency MBS purchases “at least at the current pace” in coming months, which is a rate of at least $80 billion of Treasuries and $50 billion of MBS per month.
In combination with the Fed’s recently-commenced credit facilities, this will expand the Federal Reserve’s balance sheet to $8.5-$10trn by the end of 2020 – from $7.2trn currently and $4.2trn pre-crisis.
Still too early to confidently gauge the shape of the recovery
In our view, US economic activity appears to have bottomed in late April. Last week’s gigantic positive surprise rise in May payrolls (which beat expectations by the size of the entire workforce for New York State) provided the clearest signal yet that the economy is in "healing" mode.
However, it is still far too early to declare victory in unemployment conditions, which at a 13.3% unemployment rate, is still the highest level since the Great Depression. And uncertainty around the shape of the recovery is still undeniable.
The Fed is committed to long-term support – a clear positive for credit
The Fed clearly signaled it will adopt a patient approach towards interest rates and its asset purchase programs. This is a clear sign that it will provide support as long as needed to achieve its price and labor market objectives.
The promise of continued monetary support – with potentially another $1trn of fiscal stimulus also waiting in the wings – underpins our view that the conditions for an economic rebound in H2 2020 and 2021 are being put in place. Although conditions remain uncertain, it may take until the end of 2021 for GDP to return to pre-COVID levels.
We believe these conditions will help buoy risk markets, particularly quality investment grade credits, for the year ahead.