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WashingtonWise Investor: Episode 18

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Backstops & Stimulus: How Much Will It Take?

The Federal Reserve has created an alphabet soup of programs to support virtually every aspect of the economy. But will they be enough, and which ones matter most to individual investors?

In this episode of WashingtonWise Investor, Kathy Jones, Schwab’s chief fixed income strategist, joins Mike Townsend to discuss the Fed’s extensive efforts to counter the impact of the coronavirus on the economy. They breakdown the dizzying array of far-reaching programs—from the tried-and-true to more controversial tactics—and help individual investors focus on what really matters for them.

Mike also shares insights into what Congress is doing to enhance the CARES Act and what to expect as they move forward with the next round of aid and stimulus in a “CARES 2” bill. He also considers what tax deferrals mean for not only the federal budget, but more dramatically, the toll they are taking on state governments. And in his campaign coverage, Mike looks at the myriad ways the coronavirus is impacting the 2020 election—including the 22 remaining primaries, the party conventions, and voting in the fall.

WashingtonWise Investor is an original podcast from Charles Schwab. If you enjoy the show, please leave a rating or review on Apple Podcasts.

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MIKE TOWNSEND: While a few states are beginning to slowly reopen certain businesses, much of the country remains under stay-at-home orders. And the list of ramifications can seem endless: Businesses remain shuttered, coronavirus testing remains spotty and unreliable, the wildly popular small-business loan program ran out of money in 13 days, just to name a few.

This week’s latest economic conundrum: what to do with all the oil that is flooding the market. The nation’s oil storage capacity is maxing out because demand has crashed—in no small part because no one is filling up their cars with gas these days.

For government agencies, it must feel like a never-ending game of whack-a-mole: Every time one problem is addressed, 10 more crop up. And the agency playing that game the hardest right now is the Federal Reserve.

Welcome to WashingtonWise Investor, an original podcast from Charles Schwab. I’m your host, Mike Townsend, and on this show, our goal is to help investors sift through the avalanche of news and information to better understand how this unprecedented crisis is affecting the markets.

Coming up, we’re going to explore in more detail all the programs the Federal Reserve has implemented in the past few weeks to backstop huge segments of the U.S. economy and support the markets. We’ll discuss which ones investors should be paying attention to most closely and the implications for the markets when it can feel like the Fed is backstopping, well, almost everything.

But first, let’s look at what else is at the top of the news.

Congress has been scrambling for almost two weeks to strike a deal on a bill to provide more funding for the small-business loan program that was one of the cornerstones of the CARES Act, the $2.2 trillion coronavirus aid and economic stimulus bill that Congress approved at the end of March.

That bill set aside $349 billion for the Paycheck Protection Program for small businesses with 500 or fewer employees, as well as sole proprietorships, self-employed individuals, and independent contractors. These businesses could apply for a short-term, forgivable loan to cover two months’ worth of payroll, as well as mortgage or rent payments and utilities. The loan will be forgiven if the business retains its employees.

After a rocky launch in early April, the program exploded in popularity, with more than 1.6 million loans getting approved in just 13 days before the program ran out of money on April 16 and temporarily shut down—with hundreds of thousands of businesses left in the queue. While the average loan amount was $206,000, 74% of all businesses received $150,000 or less, an indicator that the vast majority of businesses receiving aid had just a few employees whose jobs they were trying to preserve.

Now all eyes are on Congress. More than two weeks ago, Senate Majority Leader Mitch McConnell introduced a standalone bill to add $250 billion to the program. Democrats wanted to supplement that with additional funds for state and local governments, as well as hospitals. Each side objected to the other’s approach, sparking a stalemate that lasted into this week.

Finally, on April 21, the two parties announced agreement on a $470 billion bill that would allocate $310 billion for the Paycheck Protection Program; $60 billion for another aid program at the Small Business Administration, known as the Economic Injury Disaster Loans, or EIDLs; $75 billion for hospitals; and $25 billion set aside for virus testing. The Senate was able to pass the bill by unanimous consent on April 21, without having to have all Senators return to Washington to vote in person.

In the House of Representatives, however, the objection of a single Congressman forced the House to reconvene for an in-person vote, which is expected to happen on April 23. Despite the procedural hurdles, the House is expected to approve the additional funding easily.

But here’s the rub—most experts expect the new money for small businesses to be exhausted within 48 to 72 hours, given the back-up in applications. So the pressure will be right back on Congress to decide how quickly to add more funds for the programs.

That next stimulus bill is likely to come in May. Notwithstanding the emergency session of the House of Representatives this week, both the House and Senate are not expected to return to Washington for regular sessions until May 4 at the earliest. And even that date remains very much up in the air. But work on another aid and stimulus package—the so-called CARES Act 2 bill—is already underway behind the scenes.

The CARES 2 package is expected to supplement many of the programs from the CARES Act. There is talk of another round of $1,200 payments to taxpayers, further enhancement of unemployment benefits, and more money for states, cities, hospitals, and, yes, small businesses.

But I don’t expect the next bill to go as smoothly as the original CARES Act. There are so many competing priorities, so many parts of our economy in need of support, and lawmakers know they can’t support them all. But every member of Congress is going to be fighting for his or her priorities, whatever the needs of his or her constituents might be. And that could produce a much more complicated and drawn-out battle to develop consensus than we saw late last month. Investors should keep a wary eye on how this unfolds, as Congress may be forced to pick winners and losers in the next round of aid.

Elsewhere, while Tax Day was pushed back from April 15 to July 15, millions of Americans who were owed refunds went ahead and filed their taxes anyway, hoping to get that refund as quickly as possible. Now, it makes sense, of course, that if you are getting a refund, there is no reason to wait until July, while if you owe taxes, well, you might as well take advantage of that three-month reprieve.

But the IRS, which is chronically understaffed anyway, has been operating, like most businesses, with reduced staff who are working mostly from home. In addition to being short-staffed, the agency’s priority over the past three weeks has been getting those $1,200 stimulus payments out to about 150 million Americans who qualify.

So millions of Americans who are expecting tax refunds might be stuck waiting for a while. There are reports that millions of paper filings are sitting in storage bins and haven’t even been opened yet. The IRS is trying to prioritize refunds, and it has been sending them out as quickly as it can even while also sending out those stimulus payments, but it still could be weeks before it processes them all.

There’s another interesting ramification of the delay in the federal and state tax filing deadlines. Both the federal government and state governments anticipate each year a huge influx of tax payments to fill their coffers in March and April.

But that did not happen this year. In fact, The Wall Street Journal reported that on April 15 this year, the Treasury received $17 billion in payments and sent out $151 billion in payments to taxpayers, mostly in the form of those $1,200 stimulus payments. That’s an unprecedented net loss on a day that normally finds the Treasury flooded with payments. The Journal also reported that the government received 89% less revenue from individual income tax payments on April 15 of this year than it received on the same date in 2019.

Now of course, this money will eventually come in—it’s just moved to July. But where this really hurts is at the state level. Most states have aligned their tax deadlines with the federal deadline, so they, too, did not see the usual influx of payments coming in during the first couple of weeks leading up to April 15. And state budgets have much less wiggle room than federal budgets. It’s just another way that states are getting hit from every conceivable angle as the pandemic unfolds—and a key reason why Congress is expected to include more money for states and municipalities in its next economic stimulus bill.

On today’s Deeper Dive, I’m delighted to welcome back Kathy Jones, senior vice president and chief fixed income strategist at the Schwab Center for Financial Research. Kathy is our resident expert in all things Federal Reserve, and since the Fed seems to have its hand in just about every corner of the financial system these days, she’s the perfect person to help us make sense of it all.

Thanks so much for joining me, Kathy.

KATHY JONES: Great to be here, Mike.

MIKE: Well Kathy, when you were on this program a few weeks ago, you described some of the first steps the Fed took in response to the economic and market impact of the coronavirus pandemic, from lowering interest rates to near zero to easing regulations to make it easier for banks to lend. But the Fed didn’t stop there.

Over the course of the last few weeks, the Fed has launched or re-launched at least eight different programs to backstop or jumpstart various parts of the financial system. And they all have names that sound like gibberish to the average investor—the Main Street and Expanded Loan Facility and the Secondary Market Corporate Credit Facility, just to name two. In typical Fed-speak, they are all “facilities,” which is basically just kind of a fancy way to describe a program that the Fed has created to facilitate a certain kind of transaction in the financial system. So what’s the point of all these programs?

KATHY: The Fed was facing two problems as we came into this crisis. The first was that it was clear that the economy was falling into a deep recession since most economic activity was shut down. And the Fed’s job is to set policy to promote full employment and inflation at 2%. It was clear we’re not going to meet those goals with its current policies.

The second was that the markets were seizing up due to panic over the economic impact of the efforts to contain the virus. A lot of investors were simply pulling out of the markets and rushing into short-term Treasury bills—which is another word for cash. And as a result, the markets weren’t functioning properly.

The various programs can be sorted into two buckets. The first bucket are programs that are meant to directly support the economy.

And those include lowering interest rates, buying mortgage-backed securities to hold down mortgage rates. And loosening regulations on banks to allow them more capacity to make loans while encouraging them to work with borrowers to adjust payment schedules—the word they use is forbearance.

And then in the CARES Act, the Fed provided money for loans to businesses and households affected by the coronavirus.

Now in the second bucket are programs that are meant to improve the functioning of the markets—mainly liquidity. And that’s a term we use for when markets aren’t functioning properly. That’s the “alphabet soup” of these different facilities that you mentioned with long names.

Of course these overlap. You can’t have a healthy economy if there is no liquidity in the financial system. And the financial system is what gets money into the economy so households and businesses have access to loans and funds at reasonable rates.

MIKE: Well Kathy, of all the different facilities the Fed has set up in recent weeks, the one that strikes me as most important to the ordinary individual investor is the money market fund backstop. Now money market funds currently hold about $4.5 trillion in assets, according to the Investment Company Institute—and millions of investors hold these funds in their accounts, or have their cash swept into these funds every night. So why did the Fed feel it needed to backstop these funds?

KATHY: Well money market funds are really important to the functioning of the financial system. They have many of the same characteristics as bank accounts, except they invest in a wider range of assets. Most people hold some sort of money market fund account, and for the average investor, the funds are designed for a stable price, as you mentioned.

If the underlying assets are falling in value and investors at the same time are trying to access their capital, it can create a very dangerous situation for the financial markets.

And money market funds were seeing huge redemptions as investors needed to raise cash in the middle of March. Think of mutual funds that were seeing high redemptions or hedge funds that are trading on borrowed money. They needed to raise cash in a big hurry. And one way to do that is to sell money market funds. So if the money market fund had to sell assets at a time when prices were falling, then there could be problems maintaining that stable value of $1 per share.

MIKE: Well this was a problem in the 2008–2009 financial crisis when one money market fund “broke the buck,” meaning its value did fall below that $1 per share, and that sparked a panic among investors that they would not be able to get all their money out of these funds. The federal government had to intervene in that 2008 situation by backstopping these funds. So is this essentially the same program from 2008?

KATHY: It’s very similar—but this time, the Fed acted before there was a problem and helped to stabilize the market before it got out of control.

And the Fed actually had changed regulations after the 2008–2009 crisis to make sure money market funds for individual investors were more secure. They now require these funds to hold only high-quality AAA-rated assets and government securities with very short maturities. This time around, the Fed is lending to any chartered bank or broker-dealer owned by a bank or even U.S. branches of foreign banks—which purchase eligible assets from a money market mutual fund. The key is that these are “no recourse loans.” So it’s basically a backstop for money market mutual funds. And that has provided a lot of reassurance to the markets.

MIKE: Well Kathy, the Fed has also injected itself into supporting businesses of all types, from big businesses like Walmart to the small businesses that can be found in every neighborhood. So how do those programs work?

KATHY: Well, there are three main programs for businesses—and they are divided out by size.

So for small businesses there is the Paycheck Protection Program, and that was designed for businesses with up to 500 employees. It’s designed to support banks lending to small businesses that need money to prevent laying off their employees.

And then the medium-size program is called the Main Street Lending Program, and that’s for businesses with 500 to 10,000 employees. It’s probably the most novel of the programs that the Fed is doing. Since the Federal Reserve is not set up to make loans directly to businesses, it essentially has to set up a facility that allows banks to make those loans, and then the Fed will buy 95% of them.

The key is that these loans defer principal and interest for a year. This is basically the Fed providing bridge loans to these businesses.

And then there’s the Commercial Paper program for larger businesses. They tend to issue these short-term notes to raise money for things like payroll and to pay the rent in their day-to-day activities. Because there was so much skittishness among investors for these notes, the Fed set up a facility—in this case, what’s called a special purpose vehicle, financed with money from the Treasury, to buy commercial paper. And that assured that companies were able to get their funds when they needed them.

MIKE: Well, another important area for investors is the bond market. So what has the Fed done to provide confidence to investors who hold corporate or municipal bonds?

KATHY: Well, here, too, the Fed set up a couple of different facilities to help support the bond market.

The Primary and Secondary Credit Market Facilities allow the Fed to buy bonds of companies to help support the corporate bond market. Initially, it was only going to be for investment-grade bonds, those rated BBB or higher, but then allowed the secondary facility to buy a handful of high-yield bonds and even high-yield ETFs.

The Fed has never purchased ETFs before—this is brand new. And the reasoning behind it was this time they felt it was important to provide liquidity to the market at a time when the market was illiquid, and ETFs were seen as an efficient way to do that. Note that they aren’t committing to buying a lot of high-yield ETFs, nor will they buy those ETFs when the price is at a large premium to net asset value—so there are going to be limits.

The story is similar with the type of bond buying that they’re doing. They’re only buying a handful of high-yield bonds—things that we call “fallen angels.” Now these are companies that were downgraded from investment grade to high yield recently—after March 22—due to the virus. Many are large employers—so it falls under the Fed’s mandate to support full employment. And the idea here was that if you allow these companies to fail there would be a lot of knock-on ripple effects and very high unemployment, so the Fed felt the need to step in because they had only recently been downgraded from investment grade, to support those companies.

It’s controversial indeed, but nonetheless it fell under the Fed’s mandate to support full employment.

MIKE: Well, those are really important programs to support really all types of businesses from the smallest to the biggest.

Well the CARES Act created kind of an unusual partnership between Treasury and the Fed. It essentially set up a $454 billion emergency fund that could be “levered up” by the Fed into some $4 trillion worth of liquidity—can you explain how that works?

KATHY: Well, essentially when the Fed buys debt, it’s making a loan. And since it isn’t set up to lend directly to businesses, it set up a special vehicle to do that. The loans are extended—in this case to businesses—and the Fed holds those bonds. The money it’s getting from the Treasury is there to cover any potential losses from borrowers that don’t repay. Now, technically the Fed isn’t supposed to take losses because technically it is only supposed to buy Treasuries and other government-backed paper. But the bottom line is that with the money from the Treasury going into this vehicle, the Fed can buy a lot of bonds to support the economy.

MIKE: Well one way this is kind of controversial is that a main pillar of the Fed’s functioning is the independence it has from the executive or legislative branches—so does this close interaction threaten that?

KATHY: Well the Fed has indeed crossed over into fiscal policy—although they’re using emergency powers to do that—but this is not a routine part of their activities. But everything they do has to be approved by the Treasury—which is the oversight aspect of this. That was put in place after the 2008–2009 financial crisis. But it is blurring the line. It isn’t something that the Fed does lightly. It has cherished its independence from political interference for decades, but in emergencies it’s willing to do what it needs to do, and if that even involves bending the rules, then that’s what the Fed will do.

MIKE: Well another concern is that the Fed has kind of thrown everything at this effort—is that true, have they exhausted their ammunition, or do you expect more from the Fed?

KATHY: Well I like to say that the Fed never really runs out of ammunition. The reason is that the Fed creates money out of thin air—that’s what central banks do these days in the modern financial era. They add reserves to the banking system, the banks make loans, that expands the supply of money in the financial system­—that’s basically how it works.

In a situation like we’re in today, the Fed is basically trying to shovel a lot of money into a gaping hole that has opened up by shutting down the economy. If the economy continues to deteriorate from here and long-term interest rates fall, then I would expect the Fed to take more action. One thing they could do is called yield-curve control—that is, they could extend the bond buying in size and in maturity to prevent long-term interest rates from going up, or even falling into negative territory, as it has happened in Japan.

And I would also expect the Fed to continue to be creative. We don’t know what other tools they might pull out of the toolbox, but I don’t think that they will stop until they’re convinced that the economy is on solid ground.

MIKE: Well Kathy, when times get better, how does the Fed go about unwinding everything? Given how many actions the Fed has taken, combined with the unprecedented spending by Congress in the CARES Act and the other rescue bills, and with more rescue bills likely on the way, do you think anyone has given any thought to the hard choices Congress and the Fed will have to make when this crisis is over? The increase in federal deficits and the national debt will have huge implications for the future all by themselves.

KATHY: Yeah, I’m sure there are many people who are thinking about this long term, but really there are no easy answers here. Most economists believe that using fiscal and monetary policy in an emergency is the right thing to do. It’s the lesson from the Great Depression in the 1930s—not enough was done to support the economy, deflation set in, and that caused a lot of suffering and a lot of lost productive capacity in the economy. And that’s why you see some economists embracing this idea of Modern Monetary Theory, which says that fiscal policy needs to expand and contract with the economy—not just monetary policy. But that does mean living with large deficits. As long as we have the world’s reserve currency and demand for Treasuries is strong, that may not be a big problem. The issue is we don’t know when the market has finally had enough. We don’t know when it crosses that line. And that’s a worry longer term.

But whatever you believe, it will be hard to get back to a “normal” policy setting any time soon. It took the Fed nearly a decade to begin unwinding its emergency actions from the financial crisis. It wasn’t until the end of 2015 and into 2016 that the Fed started to raise short-term interest rates and reduce the size of its balance sheet. This time around, I would expect another long stretch of extraordinary policy—with interest rates staying low and deficits remaining high.

MIKE: Well Kathy, let me wrap up with this. What’s an ordinary investor supposed to make of all this? It seems like the Fed has had its hand in just about everything these days. And the idea was to boost confidence in the markets. We’ve seen that happen. The S&P 500® has rebounded 26% from its lows last month. So does that mean what the Fed is doing is working? And do you worry that this will promote excessive risk-taking by investors, if they feel like the Fed’s got their back in just about everything? 

KATHY: I do worry that investors may be rushing into parts of the market too quickly without considering the risks. I think one lesson people took from the financial crisis is that they should have jumped into the market when the Fed started to ramp up its various programs to support the financial system. At the time a lot of people were just too afraid to jump in, and they missed a good part of the rally.

Now it seems to be the opposite—people are a bit too eager to jump in because the Fed is active. For example, you’ll hear people say that, wow, since the Fed is buying high- yield ETFs, that’s the way to go. It might be appropriate for some people for a small portion of their portfolios, but these are still riskier bonds—some of which are going to be downgraded, I’m sure, or perhaps even default. The Fed won’t save every company or every investor—so we still need to understand the risk/reward balance and what’s appropriate for us as individual investors.

MIKE: Well Kathy, that’s great advice. You know, we have to keep in mind that every investor is different and we have to look at our own situation and decide what the appropriate action is. Well thanks so much for joining me, Kathy.

KATHY: My pleasure, Mike.

And now on to the Election 2020 segment of the podcast. On Friday, April 17, we passed a significant marker—200 days to go until Election Day. Every presidential cycle, about this time, we warn that it’s too early to say much about the outcome in the fall, that there are just too many steps still to go. But that’s probably never been more true than this year.

Just think of how many unknowns there are about the months ahead.

We don’t know when all of the 22 states that have yet to hold their presidential primaries will vote. While former Vice President Joe Biden is the presumptive nominee for the Democrats, he still needs to collect delegates to formally clinch the nomination.

We don’t know when Biden, as well as candidates in key races for the Senate, the House, and countless state offices, will be able to hit the campaign trail again. For now, Biden is limited to daily videos and weekly podcasts from his basement office as the only ways to get his message out to voters.

We don’t know whether this summer’s political conventions will take place. Democrats have moved their convention from July to August, one week before the Republican convention. But the idea of putting 15,000 people into a basketball arena for a political convention in August seems to grow more unlikely every day.

And probably the biggest question looming out there—we don’t know how this pandemic will affect voting this fall. Just five states conduct their voting entirely by mail. Some states have recently changed their rules to make it easier for voters to request absentee ballots, to try to reduce voting in person. But the rules are different from state to state—and in many places it would require massive education efforts to even let voters know about their options.

Officials in both parties are already wrestling with these questions—none of which have simple answers.

And if and when Congress returns to Washington next month, I expect the integrity, security, and logistics of our nation’s voting systems to become one of the most pressing—and contentious—issues on the minds of lawmakers. It’s definitely a topic I’ll be keeping a close eye on in coming months.

That’s all for this episode of WashingtonWise Investor. Please take a moment to subscribe so you don’t miss an episode. And if you like what you’ve heard, please leave us a rating or a review on Apple Podcasts or your favorite listening app—those ratings and reviews really do matter.

For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.

I’m Mike Townsend, and this has been WashingtonWise Investor. Wherever you are, stay safe, stay healthy, and, most importantly, stay home—and keep investing wisely.

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