by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] | PDF

Good morning and happy Friday!  Equity futures sold off overnight but have recovered from much of their losses.  We lead off today’s coverage with the Treasury’s decision to end support for a series of Federal Reserve backstop programs.  Pandemic news is up next, followed by an economic update and European news.  We discuss China news and close with a note about Venezuela.  Being Friday, a new Asset Allocation Weekly (AAW) is available, along with the associated podcast and chart book; this week, we take a look at the bond market.

A couple of editorial notes: first, for Thanksgiving, the Daily Comment will take a few days off, with no comment after Tuesday of next week.  We will return on Monday, November 30.  There will also be no AAW next week or Weekly Energy Update (WEU).  Second, as a reminder, starting in January, in a bid to shorten this report, we will no longer publish the AAW at the bottom of the Daily.  It will be available only as a stand-alone report but will be linked within the Daily Comment.  Here are the details:

The Fed and the Treasury:  The Treasury announced it will not extend several programs that the Fed implemented in March, including the ones for corporate credit, muni lending and the Main Street lending programs.  In the comments, we didn’t see anything regarding money market funds, but we are assuming that program will close too.  Without Treasury participation, the Fed will have to remove backstops for these various programs.  The reason is that if the Fed takes credit risk on its balance sheet, there is a chance of loss and funds from the Treasury would be needed to recapitalize the central bank.

It isn’t exactly clear to us why this program is being ended.  Our fear is that it reflects the fact that policymakers at the Treasury don’t understand how the financial system works.  The non-bank financial system is capital market lending using money markets (MMK) as a funding source.  As such, such funding is “runnable.”  MMK doesn’t have deposit insurance and a borrower using it as a source of funds could find it impossible to maintain funding in a period of crisis.  Although it is possible the Treasury doesn’t understand how the system works (we find it notable the degree of ignorance about how the current financial system operates[1]), it is also possible that this move is part of a broader “parting shot” to shape the incoming administration.  Ostensibly, the argument is that the programs weren’t being tapped and thus they were unnecessary.  That’s a bit like waking up every morning and cursing the fact that you lived and wasted that life insurance premium.

Is this a risk?  Yes, but probably not a big one.  It’s a bit like driving without insurance for a while.  That’s a risk, but if one is careful and nothing bad happens, all is well.  And, like car insurance, it can be bought and similarly the programs can always be reinstituted.  We do think the Fed understands its role; the fact that it moved in a few days to implement these programs in March when it took months in 2008 suggests institutional knowledge.  So, if markets go haywire, we should see the programs return quickly.

It is important to realize that the programs were not designed as stimulus but as insurance.  The fact that they were not aggressively used means they worked about as well as one would hope.  There has been a good deal of misunderstanding about these backstops.  We have heard complaints on podcasts that the fact that the Fed’s balance sheet wasn’t expanding is a sign the Fed wasn’t doing its job.  That being said, fears that the Fed could be used for fiscal activities and circumvent Congress are legitimate.  Ultimately, we need to make a choice—either MMK and the non-bank financial system needs to be regulated like banks or, if not, we have to accept occasional market panics.  Currently, we are trying to have the efficiency of the non-banking system but with rescues and bailouts, creating conditions of moral hazard and encouraging even more leverage and risk-taking.  The Fed’s application of backstops did stabilize the system but didn’t address the risk conditions that are created by the backstops.

• The administration is looking to take Fannie Mae (FNMA, USD 1.87) and Freddie Mac (FMCC, USD 1.76) out of receivership and put the two mortgage guarantors back into the private sector. This situation bears watching.  These two companies operated in a regulatory netherworld where they had an implicit government guarantee on the mortgage bonds they issued.  In 2008, the government had to rescue the two because of defaults on mortgages.  There is strong support for home ownership in the U.S. and thus a purely private system isn’t likely because it would raise borrowing costs.  But, a return to pre-2008 probably isn’t a good idea either.

COVID-19: The number of reported cases is 57,042,406 with 1,363,182 fatalities.  In the U.S., there are 11,720,318 confirmed cases with 252,564 deaths.  For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics.  The FT has also issued an economic tracker that looks across countries with high frequency data on various factors.  The R_t data remains grim—all but one state and territory have readings over 1, suggesting rising infection rates.  Again, this week, Mississippi has the lowest; Vermont now is the highest.

Virology:

• Pfizer (PFE, USD, 36.19) announced it will ask the FDA for emergency use authorization to distribute its vaccine. This request was expected and we would anticipate that the government will move quickly to grant the application.
• Although infection levels are elevated, treatments have improved and thus hospital stays and fatalities have declined.
  • The WHO is advising against prescribing remdesivir for hospitalized COVID-19 patients, suggesting there is little therapeutic benefit.
• Although the vaccine news is positive, there is growing concern about a rise in infections due to the holidays. The CDC has warned against Thanksgiving travel.  Airlines are reporting a drop in bookings as infections rise.  Compounding the concern is the return of college students for Thanksgiving; colleges have reported a rise in infections.
• In Europe, it appears infections have peaked, but there is a death from COVID-19 every 17 seconds.
  • The mink cull in Denmark has been a political debacle, forcing the agriculture minister to resign and may bring down the government.
  • One of the members of the Brexit negotiation team has tested positive, forcing talks to go virtual.
• Increasingly it looks like the transmission from surfaces is rare, so disinfecting measures are probably unnecessary.

Economic news:

• Real estate has been on a tear, supported by changes in generational behavior, work from home, and favorable housing affordability.  The boom is lifting lumber prices, which usually decline in Q4.

• The U.S. is releasing new rules designed to lower drug costs. There are two elements; first, payments to distributors will be reduced, and second, prices will be tied to those overseas.  The drug industry has generally opposed the measures.

Europe:  The EU summit of heads of state ended its virtual meeting.  It was a difficult gathering, with the historic stimulus plan still awaiting approval, continued uncertainty surrounding pandemic policy, and Brexit worries.  Chancellor Merkel promised to keep pressing the case, which is favorable.

• The U.K. announced a massive increase in defense spending, the largest rise since the Cold War

China:  There are reports that Katherine Tai, the chief trade lawyer for the House Ways and Means Committee, is being considered for USTR.  She is fluent in Mandarin, which suggests the focus of trade will remain on China.

Venezuela:  One feature often seen in revolutions is that the leadership turns on fellow travelers.  The Soviet leadership turned on Trotsky, for example.  In Venezuela, socialists who supported Chavez and Maduro are finding themselves on the outs as they complain about the cronyism and corruption.  In popular culture, this situation was well described in Orwell’s Animal Farm, where it was said that “all animals are equal, but some are more equal than others.”

• Opposition leaders are trying to prevent creditors from seizing assets on hopes that a new government will have access to them in the future.  Given the low odds that the opposition will be able to oust Maduro, we suspect creditors will move forward.

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[1] Here is a good book explaining it.