Co-Head of Global Bonds Nick Maroutsos discusses the US Federal Reserve’s (Fed) latest efforts to ease financial conditions and why he believes the outlook for financial markets now depends on fiscal policy.

  Key takeaways

• In our view, the Fed’s latest emergency action – to purchase a wide range of assets “in the amounts needed” and provide additional lending support to businesses and consumers – was a step that the central bank eventually had to take to ensure financial market liquidity.
• However, we think policy initiatives must now shift from the Fed to the legislative branch.

In the past few weeks, the US Federal Reserve has called multiple emergency meetings, lowered its benchmark policy rate to zero, announced quantitative easing and introduced measures to improve liquidity in money markets. It has not been enough. On 23 March 2020, the Fed called its third emergency meeting, announcing that it would, essentially, buy whatever securities necessary to ensure financial market liquidity, expanding the scope of its asset purchases to include everything from corporate bonds to exchange-traded funds (ETFs). In its statement, the Fed said it was scrapping previous targets for securities purchases and would instead buy “in the amounts needed.” The Fed also announced new lending programmes to support the flow of credit to businesses and consumers.

In our view, this was a step the Fed had to take eventually. It is also difficult to envisage what else the central bank could do in the near term. The urgency for policy initiatives now shifts from the Fed to the legislative branch. While neither the Fed nor Congress can address the virus, the Fed has used monetary policy to support market liquidity. Now, it is up to Congress, in coordination with the Trump administration, to provide large-scale fiscal stimulus.

To begin to stabilise, financial markets need the assurances provided by the Fed to be active buyers in today’s volatile markets. Even if valuations of some securities may look attractive based on long-term outlooks for the economy, illiquidity risk is difficult to price and difficult to manage. Diminishing liquidity risk across the credit markets provides real relief. But ultimately, valuation depends on the economic outlook. Investors need a better understanding of the breadth and depth of the likely recession and confidence that a fiscal response – appropriately scaled to the severity of the economic impact – is coming.

James Bullard, president of the St. Louis Federal Reserve, said US gross domestic product (GDP) could fall 50% during the second quarter and that unemployment in the US could hit 30%. With annual GDP around US$22 trillion, a 50% drop in one quarter of GDP would be a shortfall of around US$2.75 trillion dollars. While better liquidity in financial markets is necessary, it is not sufficient to make up that kind of a production and revenue shortfall.