Government support

| June 12, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Fed QE has worked beautifully so far, lowering rates, steepening the yield curve and tightening spreads even in assets the Fed does not buy. But markets are getting an underappreciated lift from fiscal policy, too. The federal government in April alone poured $250 billion directly into consumers’ pockets and has distributed $510 billion so far in Paycheck Protection Program loans to small business, of which 75% will likely go to payroll. Personal income, employment and mortgage forbearance all show the imprint. Fed support for QE and easy policy is clear, but federal support for more spending is not. That is the next risk the market will have to manage.

CARES Act has an immediate impact on personal income

The CARES Act and amendments to it authorized $2 trillion in spending with more than 60% of it going as cash directly to small businesses and individuals. That included the PPP at $687 billion, rebate checks to individual taxpayers of $293 billion and expanded unemployment benefits of $269 billion (Exhibit 1). That money has had an immediate impact on fundamentals.

Exhibit 1: Most CARES Act spending targets business and individuals

Note: PPP funding came from the CARES Act and amendments authorizing an additional $310 billion in PPP spending. Source: Congressional Budget Office preliminary estimate of CARES Act costs available here.

In April, despite a $73 billion loss in employee compensation, government transfers of nearly $250 billion helped push US personal income to a nearly $164 billion gain (Exhibit 2). More than 85% of that transfer came from $1,200 checks sent to eligible taxpayers. Another 12% came from unemployment benefits, with a substantial lift from CARES Act federal unemployment benefit of $600 a week. A small amount of unemployment benefits also went to sole proprietors, consultants and others not usually eligible. The CARES Act also extended unemployment benefits for 13 weeks for individuals who have exhausted state benefits, which resulted in a small transfer in April.

Exhibit 2: Changes in personal income from prior month

Source: Bureau of Economic Analysis

The rise in personal income and a drop in personal spending resulted in an April savings rate of 33%, the highest since the US began keeping records in the 1960s. Much of the drop in spending likely came from having less opportunity to spend, with many businesses shut down in April. Spending should rise, including the savings from April.

The mortgage market has felt the impact of fiscal policy indirectly through a surprising low rate of update for forbearance. Despite unemployment in the low teens in April and May, reports from mortgage data provider Black Knight show forbearance in the last two weeks has started to decline. As of June 9, only 8.8% of borrowers had taken forbearance. Mortgage originators report that borrowers prefer to make payments if they are able rather than take forbearance, and many take forbearance as a liquidity backstop and still make loan payments. CARES Act spending has clearly facilitated that.

April and May unemployment suggest the impact of PPP

The impact of PPP is less distinct, but the latest employment report suggests it is making a difference. PPP lending only started in early April during the second half of the April unemployment survey window (Exhibit 3). After exhausting the initial round of $349 billion, a second round of $310 billion in PPP funds became available in early May.

Exhibit 3: PPP loans outstanding ramped up in early April and again in May

Note: Dark blue shows PPP loans from Phase I and light blue from Phase II. Source: American Action Forum

PPP likely had a small effect on April unemployment and a large effect in May.

Private payroll employment went from a loss of 19.6 million jobs in April to a loss of 2.8 million in May. Employment in some industries particularly affected by social distancing also swung significantly from April to May. Leisure and hospitality went from a loss of 7.5 million jobs in April to a gain of 1.2 million jobs in May. Retail went from a loss of 2.3 million jobs in April to a gain of 368,000 jobs in May. Healthcare and professional and business services also went from losses of millions of jobs in April to gains of hundreds of thousands in May. Part of the economy did start opening in May, but PPP requires borrowers to bring payrolls back to pre-March levels in order to earn forgiveness, and May looks like the beginning of the process.

As the household balance sheet goes, so goes market fundamentals

Arguably the most important aspect of fiscal spending in this crisis is that it is going to recipients likely to spend it and drive growth and employment up. Economist Daniel Wilson at the Federal Reserve Bank of San Francisco estimates that authorized spending so far could drive GDP up by 11% for several years in a row. This is in contrast to monetary policy provision of funds at low rates to banks. After 2008 and again in recent months, banks have kept most of the funds in excess reserves with limited real economic impact.

While monetary policy has had a clear impact on asset prices, fiscal policy is having significant impact on small business and individual balance sheets. With consumer spending nearly 70% of GDP, as the consumer goes, so goes growth and employment. And as growth and employment goes, so goes the consumer and corporate credit backing large parts of the US fixed income markets.

Hedge an uncertain commitment to continued fiscal spending

With enhanced unemployment benefits due to expire on July 31 and the vast majority of the PPP spending also done in July, that month should bring a new policy debate on more spending. Differences of opinion on the strength of the economy, deficit spending and incentives to work should sharpen.

It is unlikely in July that the economy will be able to stand on its own, so market volatility will likely pick up. Higher volatility tends to widen all spreads from mortgages to corporate debt. The best hedge is to get long volatility now, before the debate begins in earnest.

It seems most likely that policymakers and politicians will ultimately agree to spend more money. Leaving an economy at risk does not seem like a great way to get elected in November. But that has rarely stopped a little brinksmanship in the meantime.

* * *

The view in rates

The June FOMC brought the Fed’s economic projections back and confirmed the market’s expectations that the Fed will keep rates near zero through 2022 or beyond. The current 0.70% rate on 10-year Treasury debt implies an average real rate of -51 bp and inflation of 122 bp. Implied inflation has continued to climb since mid-March. That should keep pressure on the yield curve to steepen from 2-year to 10-year and from 5-year to 30-year.

The view in spreads

The Fed, banks, money market funds and lately fixed income mutual funds all have sizable amounts of money to spend, and their demand for high quality assets should keep squeezing spreads tighter. As spreads tighten in the highest quality assets, investors will have to move to the next tier of higher risk to get sufficient spread, but it is likely to happen. There is fundamental risk in the most leveraged corporate balance sheets, and only there might spreads continue lagging the rest of the market.

The view in credit

Prices on leveraged loans, rating agency downgrades in leveraged loans and high yield and rising bank loan loss reserves signal a wave of distressed credit. Rising unemployment and delinquency rates in assets from MBS to auto loans show pressure on the consumer balance sheet. However, monetary and fiscal policies are both shoring up these fundamentals. The course of leveraged corporate and consumer credit also depends on renewal of CARES Act unemployment benefits and support for small businesses, along with moratoriums on eviction and foreclosure.

john.killian@santander.us 1 (646) 776-7714

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