Time was, the primary role of a central bank was to monitor and regulate the supply of money. The mission was to maintain stable prices, and not let inflation rage out of control. How far we have travelled. Once relegated to holding only US Treasury bonds, the Fed has now embarked on its first ever purchase of individual, private-sector corporate bonds and Exchange Traded Funds. RIP Milton Friedman.
As part of its emergency response to the economic carnage from Covid-19, the US Federal Reserve announced in March a bold new gambit to help stabilize the corporate bond markets: stepping directly into the credit markets to backstop individual companies. Taking a page from Ben Bernanke’s 2008 playbook and soaking it in steroids, the move is sure to trigger a renewed debate over the limits of Fed power and just where the line between monetary and fiscal policy should be drawn.
Last week, the Fed announced the somewhat surprising list of its first corporate bond purchases. The buys included some of the biggest and best-capitalized companies in America: AT&T, Walmart, Comcast, UnitedHealth Group, and CVS among them. Some of the choices were controversial: oil companies like Exxon, Energy Transfer and Diamondback Energy, and tobacco company Philip Morris International are now held in the portfolio of the US central bank. A division of Warren Buffet’s Berkshire Hathaway, which sits on a $137 billion cash pile, was also on the menu.
The Fed purchased Exchange Traded Funds (ETFs) as well for the first time, including some that hold so-called “junk” bonds (bonds of companies with less than an investment grade ratings, due to their substantially higher risk of default). And candidates for future purchases include US divisions of foreign companies like Toyota, Daimler and Volkswagen. In the aggregate, roughly half of the purchases were rated “BBB”, the lowest notch above junk and the kind of paper the Fed in a more rational world dare not mention much less own.
In principle, the central bank should function as a lender of last resort during periods of extreme duress in order to guarantee liquidity and alleviate the freezing up of the financial pipes. Of course no one imagined the suddenness and severity of the economic damage from the virus, and the Fed to its credit acted swiftly. This and several other emergency measures were announced in March and had the desired effect: the minute the Fed said it would buy bonds, the market unfroze. So much so that during the first 6 months of 2020, over $1 trillion in new corporate debt has been issued, far exceeding any previous full-year period. And so much so that demand for bonds exceeds supply, driving interest rates to all-time lows.
So the mystery is this: why did the Fed go ahead and start buying bonds, when the market had already become unstuck? The specific program is known as the Secondary Market Corporate Credit Facility (SMCCF), designed to allow the Fed to purchase bonds in the secondary market. These are bonds that have already been issued and for which the companies have already been paid. The purchase of these bonds in the secondary market has no impact on the issuing companies, but essentially serves to levitate asset values.
Many critics worry that the Fed is creating a moral hazard by bailing out bondholders now that the credit markets are functioning efficiently, creating an asset bubble (or injecting more gas into the current balloon). With the traditional monetary tools rendered largely ineffective, the game has shifted to propping up stocks and bonds and hoping that some of the juice flows downhill toward Main Street.
Congress will debate the limits of the Fed’s authority in the postmortem of the Covid crisis. But without question, many of the foundations of the free market have shifted in the direction of increased government intervention, with unknown longer-term consequences. For now, whatever it takes.
Christopher A. Hopkins, CFA