It has only been two months since the stock market hit its low point following the Covid-19 sell-off. Yet, if you are like me, it probably feels like a lifetime ago. The sell-off was rapid and indiscriminate. Not only did stocks fall quicker than ever before, bonds sold off as well.
Then, when things were bleakest, the Federal Reserve rode to the rescue. Pulling several pages out of its 2008 financial crisis playbook, the Fed intervened in historic fashion. It backstopped money markets and several areas of the bond market. And it indicated a willingness to support the equity markets if need be. Much like it did post-financial crisis, the Fed began to buy bonds, expanding its balance sheet to $7 trillion! To put this in perspective, the Fed’s balance sheet previously peaked at $4.5 trillion at the end of 2014.
The good news is the Fed’s quick actions worked. Markets settled down, stocks rallied, and bonds began to behave like bonds again. The question now is where does the Fed go from here?
In its April meeting notes, the Fed indicated it may make future Fed policy more predictable. Since Alan Greenspan, the Fed has become more transparent about monetary policy, using press conferences, detailed minutes, and data projections. Giving explicit forward guidance to investors about when and if it will raise rates based on specific unemployment or other targets would be another potential step towards an even more transparent Fed. It could remove an element of uncertainty. And we all know that if there is anything markets don’t like, it’s uncertainty.
Another wrinkle in Fed policy is what’s known as yield-curve control. This involves a targeted capping of yields on government bonds at a chosen maturity. The Fed would buy as many bonds at the chosen maturity as it takes to reach a targeted yield. It is a way of controlling borrowing costs for investors, consumers, etc. Japan has done this for a long time and Australia started doing it in March. It would also be a way for the Fed to take action to stimulate the economy in lieu of additional fiscal measures from Congress.
Another monetary policy tactic is negative interest rates, which have been tried by other countries. While some investors are still betting the Fed will follow a similar path, Fed officials have continuously unanimously rejected the idea.
Yield-curve control is not a new policy. It was used by the Fed during World War II. In order to help finance the war, the Fed capped 30-year bond yields. This time, if the Fed decides to go this route, it would likely focus on shorter-term bond yields. This would provide additional monetary stimulus if the government can’t pass additional fiscal stimulus. And, it would give the Fed the ability to shift away from yield-curve control and tighten if economic conditions improve.
What does this mean for investors? Less potential uncertainty for one which is good for the stock market. And more predictability as well for interest rates which is good for the bond market.