The US ABS market has come a long way since the sell-offs earlier in the year as the coronavirus pandemic took hold. Recently, spreads for both plain vanilla and off-the-run sectors have tightened back to pre-pandemic levels. Moreover, investor sentiment rose further this week thanks to recovering US unemployment as well as the reopening of New York City and other major cities from lockdown.
But it is too early to celebrate, not only because there is a high chance of a second wave of Covid-19 infections to come in the fall, but moreover, because the Federal Reserve will likely put the breaks on easing measures in its July meeting. Many believe the next stimulus package from Congress slated for July is going to be the last one we see.
Most market participants point to the Fed’s prompt response as the primary reason behind a quick recovery, including its Term Asset Backed Securities Lending Facility (TALF 2.0) and its various liquidity facilities. The government stimulus package was another huge contributor that kept consumers afloat through historic unemployment numbers, softening the blow the ABS market would have suffered otherwise.
We’ve seen time and time again that the market is extremely fragile, and especially sensitive to the Fed’s language. If the next stimulus package does not meet expectations, or if Fed chairman Jerome Powell signals that the central bank is throttling back, the market will flounce like it did when the Fed proposed winding down its original financial crisis-era stimulus in 2013's 'taper tantrum.'
With the market appearing to function and with spreads under control, the Fed has no reason to introduce more stimulus. It’s not going to move interest rates or cut off any existing lines of support, but Powell will likely tone down his language while acknowledging that economic conditions are still dire.
Many investors are not pricing in the risk of another spike of the virus and are assuming that the market is mostly back on track to a smooth recovery. They are also not pricing in the fact that the stimulus has to stop eventually.
But most are only focusing on the positives, such as the recovering unemployment numbers and the growing list of cities reopening. So the Fed’s next message about stepping off the gas pedal, however it phrases it, will quite likely spook the market.
Numbers point to everything but a V-shaped recovery and it is dangerous to assume that we’re passed the worst point. Without a vaccine, the virus could resurge just as lockdowns end. That will see market confidence evaporate but investors need to have far less trust in the Fed riding to the rescue regardless than they are showing now.