U.S. SECURITIES AND EXCHANGE COMMISSION

U.S. SECURITIES AND EXCHANGE COMMISSION

Division of Economic and Risk Analysis

DERA

Economic

and Risk

Outlook

S.P. KOTHARI

Director and Chief Economist

and

NOVEMBER

19

2020

DERA Research Staff

Table of Contents

Key Highlights...................................................................................................................................1

The Path of New COVID-19 Cases Is Uncertain............................................................1

The Effects of the COVID-19 Recession on Employment Remain

Uneven as Policymakers Contemplate Further Stimulus.........................................2

Equity Markets Have Recovered Faster than the Overall Economy.................. 4

The Economic Impact of COVID-19 Remains Uneven.............................................. 4

Both Households and Firms Have Bolstered Their Cash Positions.....................7

Financial Market Risk Proxies Remain Elevated..........................................................8

Macro-Financial Overview...........................................................................................................9

Economic Fundamentals and Growth.............................................................................9

Monetary Policy and Interest Rates............................................................................... 13

Financial Market Signals..................................................................................................... 18

Market Segments.......................................................................................................................... 21

Markets...................................................................................................................................... 21

Mutual Fund, ETF, and Money Market Fund Investors.......................................... 24

Borrowers, Securities Issuers, and Capital Formation........................................... 26

Spotlights......................................................................................................................................... 31

The Commercial Paper Market and Money Market Funds.................................... 31

Summary: Virtual Roundtable on Interconnectedness

and Risk in U.S. Credit Markets....................................................................................... 36

The Division of Economic and Risk Analysis (DERA) advances the Commission’s statutory mission to protect

investors, maintain fair, orderly, and efficient markets, and facilitate capital formation through sound economic

analysis and rigorous data analytics. DERA engages across the entire range of the agency’s functions, including

rulemaking, examination, and enforcement. Its multi-disciplinary analyses are informed by research insights and

they rely on the knowledge of institutions and practices when examining regulatory and risk-related matters. DERA

assists the Commission in its efforts to identify, analyze, and respond to economic and market issues, including

those related to new financial products, investment and trading strategies, systemic risk, and fraud. DERA’s data

analytics work develops a variety of financial and market data analysis tools, gathers economic statistics, and

promotes data standards. DERA economists publish regularly in top peer-reviewed journals, including the Journal

of Financial Economics, the Journal of Labor Economics, and the Review of Financial Studies.

DERA Research Staff: Chandler Lutz (Lead Economist), Gregory Allen, Woodrow Johnson, and Pamela Urban.

OPA Design Team: Chris Gamboa-Onrubia, Zehra Sikandar, Jennifer White, and Steve Fultz.

Disclaimer: The SEC disclaims responsibility for any private publication or statement of any SEC employee or

Commissioner. This article expresses the authors’ views and does not necessarily reflect those of the Commission,

the Commissioners, or members of the staff. This report contains a non-exhaustive aggregation of information

and is one of several elements of the SEC’s risk and market monitoring efforts.

sec.gov/dera

Key Highlights as of November 15, 2020

Following the historic and unprecedented COVID-19 economic shock in March 2020, financial

markets over the past 8 months have nearly fully recovered, credit spreads have tightened,

economic activity is rebounding, and employment growth has been steady. This progress

has occurred despite the recent rise in COVID-19 cases in the United States, Europe, and in

some other parts of the world. The ongoing economic expansion illustrates how economies

have been resilient in coping with the effects of COVID-19, at least until vaccines are broadly

distributed. Yet the path of economic output as measured by gross domestic product

(GDP) remains below its pre-pandemic trend, and the recovery remains uneven as COVID19-induced economic distress continues to weigh on certain sectors. Thus, policymakers

are contemplating further economic stimulus. Moreover, both households and firms have

bolstered their cash positions by increasing savings rates or taking advantage of historically

low interest rates. Indeed, capital market activity has recently accelerated as households

have refinanced mortgage debt, corporations have increased borrowing, and firms have

increasingly entered public markets through initial public offerings (IPOs) or Special Purpose

Acquisition Companies (SPACs).

The Path of New COVID-19 Cases Is Uncertain

After Falling for Several Weeks, the Rate of New U.S. COVID19 Cases is Trending Upwards: The number of new confirmed

COVID-19 cases peaked at over 450,000 per week in late

July 2020 and then dropped to a weekly rate of fewer than

250,000 by mid-September (Figure 1.1). Similarly, newly

reported deaths dropped to a rate near 5,000 per week,

after reaching more than 15,000 per week in mid-April.

The declining rate of new COVID-19 cases and deaths led

policymakers to partially reopen certain local economies.

Although the number of new deaths continues to hold steady,

data as of November 13 show that the number of new

confirmed COVID-19 cases has risen to a weekly rate of more than 750,000. This uptick in new

cases highlights the uncertainty over the path of COVID-19 going forward, as the world waits

for the distribution of COVID-19 vaccines, and has prompted some local and state authorities to

reverse or delay reopening protocols as a response.

DERA ECONOMIC AND RISK OUTLOOK | 1

The Effects of the COVID-19 Recession on Employment

Remain Uneven as Policymakers Contemplate

Further Stimulus

The Effects of the COVID-19 Recession on Employment

Remain Uneven Across Sectors: Following the partial economic

shutdown due to COVID-19, by April 2020 employment

as measured by non-farm payrolls fell nearly 15% from its

pre-pandemic highs (Figure 1.2; green line). Then, as citizens

adjusted to public health measures and as local economies

partially reopened, job gains quickly accelerated. These gains

were concentrated in the sectors most hard-hit by the economic

lockdowns associated with the pandemic (DERA Economic

and Risk Outlook, July 2020; p. 1). While the economy

continues to add jobs, job growth appears to be decelerating.

This deceleration is likely because of the lingering effects of

the pandemic, elevated job separation rates that continue

to exceed pre-pandemic levels (Figure 1.3), and as the most

immediately beneficial labor market firm-worker matches have

likely already been realized. Data through October indicate

that employment remains nearly 6.5% below its pre-pandemic

highs (Figure 1.2; green line).

The pace of the economic recovery has been uneven, with some sectors performing better than others.

Employment in the leisure and hospitality sector was directly hit by COVID-19-induced physical

distancing protocols and thus fell markedly (DERA Economic and Risk Outlook, July 2020; p. 7).

Likewise, the large decline in aggregate demand for raw materials due to COVID-19-related economic

distress negatively impacted employment in the mining industry. Yet job losses in other industries have

not been nearly as severe (Figure 1.2; red line), with employment in all industries except the leisure,

hospitality, and mining sectors dropping only 4.7% from January to October 2020. There have also

been relative bright spots across the U.S. jobs landscape. For example, employment in the financial

sector (Figure 1.2; blue line), including the banking, insurance, and real estate industries, has remained

relatively flat throughout 2020. Similar positive employment dynamics have also transpired in other

industries, such as in the online retail and technology sectors. Broadly, for the United States to return

to full employment, jobs will have to grow markedly from their current low base in severely affected

industries (e.g., leisure and hospitality), the share of employment in less affected industries will have to

increase relative to the overall labor force, or a combination of the two.

2 | U.S. SECURITIES AND EXCHANGE COMMISSION

Following Unprecedented Policy Actions, Policymakers

Are Considering Further Fiscal Stimulus To Combat the

Continued COVID-19-Induced Economic Slowdown:

Following the COVID-19-induced economic shock in

March, Congress passed and the President signed the

CARES Act, which provided funding to help stem the rise in

unemployment, as well as battle the health and related effects

of the pandemic. Simultaneously, the Federal Reserve (Fed)

implemented unprecedented monetary stimulus, lowered the

fed funds rates to zero, announced unlimited purchases of

Treasuries and agency mortgage-backed securities (MBS) and introduced a number of liquidity, purchasing,

and lending facilities to further stabilize financial markets. Recently, the Fed announced that it would

pursue an “average inflation targeting” approach, wherein it would target an average 2% inflation rate

over time. Following episodes of limited price growth, the Fed would let inflation run moderately over 2%,

thus its medium- or long-term forward guidance would likely signal lower future interest rates. Altogether,

these actions, along with the uncertain future path of the economy, have contributed to near historically

low interest rates for the U.S. government, firms, and households (Figure 1.4). Yet despite the continued

exceptional monetary stimulus, elevated unemployment persists (Figure 1.2). Moreover, as noted by Chair

Powell, new Fed policy tools are lending programs, not spending programs (Congressional Testimony; 202009-22) and typically target borrowers with the ability to repay their debts. Hence, legislators are considering

direct fiscal stimulus to aid households and firms facing more challenging circumstances, but uncertainty

persists as to the exact timing and extent of any aid packages. Yet as suggested by Chair Powell, the “risks of

policy intervention are still asymmetric,” where fiscal policy actions that “ultimately prove to be greater than

needed…will not go to waste” (Chair Powell Speech; 2020-10-06).

While fiscal aid in response to COVID-19 has totaled

approximately $3 trillion thus far, U.S. Government debtservice payments and borrowing rates remain low. Figure 1.5

shows that although tax receipts are falling and government

debt is rising because of the COVID-19 recession, debt-service

payments (e.g., Federal debt interest expenditures relative to

GDP) remain low. The low Federal debt payment-to-GDP

ratio is a direct consequence of historically low Treasury

yields (Figure 1.4). Moreover, elevated government deficits

do not appear yet to have “crowded out” other borrowers

by increasing interest rates in other asset classes (Figure 1.4),

a concern traditionally associated with elevated government

borrowing (Blanchard, 1991. “Crowding Out.” The World

of Economics.), or sparked expectations of elevated inflation

rates (Figure 1.6). Thus, there appears to be room for the

Federal Government to expand borrowing, at least in the

near term, to implement further fiscal stimulus.

DERA ECONOMIC AND RISK OUTLOOK | 3

Equity Markets Have Recovered Faster than the

Overall Economy

The Pace of the Equity Market Recovery Has Eclipsed

Economic Recovery: Although recent data suggest that

the economy remains below full employment (Figure 1.2),

equity market performance coming off recent lows in March

2020 has been notable. Figure 1.7 highlights the relatively

faster pace of the recovery in equity markets by plotting the

growth in actual values and forecasts of GDP tabulated by

MarketWatch (panel A) and the S&P 500 (panel B) from

2019Q4. GDP fell by over 10% in the first half of 2020.

A rapid GDP decline of this magnitude is unprecedented;

in comparison, during the 2008-09 Great Recession, GDP

fell only 4% from peak to trough over a 2-year period. In

contrast, the S&P 500 has nearly recovered from its March

lows, increasing over 50% from March 23 to November 13.

As noted in the previous issue of the DERA Economic and Risk Outlook, several factors in isolation

or in combination may have contributed to the recent run-up in equity prices, including (1) COVID19-induced increases in the frequency of internet shopping and remote work–trends that favor large

technology firms, which constitute a substantial portion of value-weighted equity indices; (2) low

expected interest rates that increase the present value of future profit streams; and (3) anticipation that

the pandemic will not continue much longer, in part because of possible vaccine availability. The rapid

recovery of financial markets relative to the real economy, including unemployment rates, and in spite

of the recent uptick in COVID-19 cases, is indicative of the economy’s resilience as people cope with

and live with COVID-19 and the related public health measures. Still, some sectors of the economy

continue to experience severe stress.

The Economic Impact of COVID-19 Remains Uneven

The COVID-19 Pandemic Has Had Outsized Negative

Impact on Younger Workers: Figure 1.8 plots employment

growth by age from January 2020 for the 25-34 (blue line)

and 35-44 (red line) age cohorts, two age groups in the prime

years of their earnings lifecycles. Although employment has

fallen for both age groups, younger workers have suffered

from more severe job losses: through October 2020,

employment for the 25-34 age group is down 6.3% versus

4.6% for the 35-44 age group.

4 | U.S. SECURITIES AND EXCHANGE COMMISSION

The relative employment decline for younger workers is also large when compared to other economic crises. For

example, during the Great Recession, employment from peak to trough fell only 5% for the 25-34 age cohort

versus 7% for the 35-44 age cohort. Yet the larger decline for 25-34 versus 35-44 aged workers during the current

recession may be related to the industry employment makeup of the two groups. Those in the 35-44 cohort are

more likely to work in management positions or in financial operations, positions that have been relatively less

affected by the COVID-19 recession. According to BLS data, 19% of workers in the 35-44 age cohort worked in

those types of positions during 2019, compared to 15% for the 25-34 age cohort. Moreover, younger workers are

also more likely to work in the food services industry (5.3% (25-34) versus 3.5% (35-44), according to 2019 BLS

data), one of the industries most adversely impacted by the COVID-19 health protocols (DERA Economic and

Risk Outlook, July 2020; p. 1).

The Large Firms Outperformed Small Firms in the Immediate

Aftermath of COVID-19-Induced Financial Market Distress, but

Returns Have Been Similar Recently: Figure 1.9 shows that during

COVID-19-induced financial market distress in March, the S&P

50, an index of the 50 largest companies, dropped only 26% from

January 1 to March 23, 2020, whereas returns on the Russell

2000, an index of small firms, fell 40% over the same period. The

larger drop for the Russell 2000 coincides with COVID-19’s likely

outsized impact on the often more volatile income and revenue

streams of smaller companies. The outperformance of large firms

during March may also be related to the strong financial position

of large firms in the lead-up to the pandemic as well as the sectoral

makeup of firms in the S&P 50. The large firms that make up the S&P 50 generally have business models well suited

to cope with the changes in consumer and firm behavior, such as those induced by COVID-19 health and physical

distancing protocols. Then after financial distress eased in April, both the S&P 50 and the Russell 2000 moved

upwards in parallel, highlighting the broad-based recovery in financial markets. Yet over the plotted sample period, the

returns on smaller companies (Russell 2000) have yet to fully catch up to the returns on larger companies (S&P 50).

The COVID-19-Induced Shift to Online Shopping Has Led

to Exceptional Equity Returns for Internet Retailers: As

health protocols have encouraged households to maintain

physical distancing or reduced capacity within business and

offices, consumer behavior has changed dramatically. This has

accelerated the trend towards online shopping, and away from

traditional retail consumption, at least in the near term. As a

result, returns on equity for online retailers (companies with

at least 70% of their revenues from internet sales) have been

exceptional (Figure 1.10), both soon after the introduction of

COVID-19 health guidelines as well as more recently. The strong

recent equity performance of online retailers, relative to broader market indices, likely indicates that stock market

investors expect the trends favoring online retailers to continue over at least the near- and medium-term.

DERA ECONOMIC AND RISK OUTLOOK | 5

Delinquencies in Commercial Mortgage-Backed Securities

(CMBS) are Concentrated in Lodging and Retail Properties:

With the advent of COVID-19 health restrictions, households

markedly altered their lifestyles, minimizing travel, hotel stays,

and physical shopping. As a result, hotels and retail stores

have suffered from corresponding sharp declines in demand.

In the commercial mortgage space, these dynamics have led

to increased delinquencies for commercial loans backed by

hotel and retail properties. Indeed, Figure 1.11 shows that

delinquency rates for loans backed by lodging establishments

(e.g., hotels) sold into CMBS reached over 26% (red line)

and over 11% for those backed by retail properties (purple line). At the same time, through the summer

of 2020, delinquency rates for loans backed by multifamily (green line) and office (blue line) properties

remained flat.

On the multifamily side, over 85% of outstanding multifamily commercial mortgages sold into

CMBS are backed by government-sponsored agencies (e.g., Fannie Mae and Freddie Mac) and

thus are perceived to carry no credit risk. Not surprisingly then, the delinquency rate in the CMBS

multifamily sector is low. More broadly, many distressed renters received fiscal assistance via

unemployment and other benefits through the CARES Act and related policies that allowed them to

continue to make rent payments. Yet as the economic effects of the pandemic linger, both landlords

and tenants have become increasingly concerned that distressed households may not be able to

sustain rent payments going forward. Delinquency rates for loans backed by office properties have

also remained relatively low despite the notable uncertainty in the future of urban and remote

work. The low delinquency rate in the office category is likely a direct consequence of the longer

leases that firms and related entities sign for such properties (SEC staff report, U.S. Credit Markets

Interconnectedness and the Effects of the COVID-19 Economic Shock, p. 73), which may push any

COVID-19-related delinquencies for this category further into the future. Yet, like in the multifamily

sector, the most recent data indicate that delinquencies on office properties have increased only

slightly.

Home Values in Suburban Neighborhoods Have Increased, While House Prices in the Densest Zip

Codes Have Remained Flat or Fallen Slightly: The economic fallout associated with the COVID19 recession has also created notable and heterogeneous effects across asset classes, but the degree

of price heterogeneity (e.g., variance) in some cases is smaller than the heterogeneity experienced

in more liquid markets, such as equity markets (Figures 1.7, 1.9, and 1.10). For example, price

heterogeneity has surfaced across residential real estate markets, perhaps reflecting buyers and

sellers adjusting preferences to account for COVID-19 physical distancing protocols and associated

economic restrictions. Yet the variance in price realizations across housing markets has been

noticeably small, even as media reports highlight substantial changes in housing preferences, for

example, from urban to suburban locations.

6 | U.S. SECURITIES AND EXCHANGE COMMISSION

Figure 1.12 summarizes these dynamics by plotting house price

growth by population density at the 99th percentile (most

dense, urban zip codes; green line) and the 75th percentile (more

suburban zip codes; red line), as well as the house price growth

for Manhattan, New York (blue line). House prices for relatively

more suburban areas (red line) have increased with elevated

buyer demand. However, house prices in the most dense zip

codes have barely budged. This limited price variance highlights

a unique feature of the COVID-19 recession. Unlike the Great

Recession that emerged as a result of excesses in the economic

and financial system, the current downturn materialized

as a result of an exogenous shock: the pandemic and related health protocols. Thus, once the government

implemented monetary and fiscal stimulus and COVID-19-induced financial distress eased, distressed sellers

were few. With few distressed sellers, the asset fire sales often associated with economic crises largely did not

occur. Potential sellers in relatively stable financial positions thus may have been reluctant to sell at depressed

prices. In dense housing markets, the combination of low current demand and such reluctant sellers manifests as

a small change in realized prices, but a large reduction in transactions. Similar dynamics have played out in other

markets, like commercial real estate (SEC staff report, U.S. Credit Markets Interconnectedness and the Effects of

the COVID-19 Economic Shock, p. 73).

Both Households and Firms Have Bolstered Their Cash

Positions

As Economic Uncertainties Persist, Household Savings

Rates and Firms’ Available Cash on Hand Have Increased:

As COVID-19-induced economic distress and uncertainty

permeated across markets, both households and firms bolstered

the cash on their balance sheets. Indeed, the household personal

savings rate spiked to over 30% in April 2020 (Figure 1.13),

its highest realization during the post-WWII period. This

elevated savings rate is likely due to a combination of factors,

including precautionary savings by households, COVID-19induced partial economic lockdowns that limited consumption

choices and household mobility, as well as a reduction in

other debt-service payment (e.g., mortgage payments through

refinances) due in part to historically low interest rates (Figure

1.4). As local economies have reopened and as households have

adjusted to COVID-19 health protocols, the personal savings

rate has retreated somewhat but remains nearly double its prepandemic levels.

DERA ECONOMIC AND RISK OUTLOOK | 7

Similarly, firms have increased available cash on hand, perhaps due to uncertain revenue outlook

and attractive interest rates. Figure 1.14 plots the available days of cash on hand by firm credit

rating. The figure shows that there has been a broad-based increase in cash on hand across all firms

during 2020. Yet the largest increases in cash holdings (relative to average operating expenses) have

been concentrated in firms without a credit rating (blue line) or with an investment grade rating

(green line). This increase in cash on hand is likely driven in part by low interest rates (see Figure

1.4), economic uncertainty moving forward, and also perhaps by limited investment opportunities

for both firms and investors.

Financial Market Risk Proxies Remain Elevated

The Corporate Default Spread and the VIX Index

Have Declined From their COVID-19-Induced Highs

but Have Not Returned to Their Pre-COVID-19 Levels:

After spiking in late March, two broad proxies of financial

market risk, the corporate default spread (Baa - Aaa

bond yields) and the Chicago Board Options Exchange

(CBOE) Volatility Index (VIX), a proxy for equity market

uncertainty, have fallen (Figure 1.15). The reduction in these

risk proxies indicates that previous financial market tightness

and uncertainty have eased. Yet both indices remain well

above their pre-COVID-19 levels, suggesting that material

uncertainties remain.

Data Sources and Notes: Figure 1.1: The New York Times, based on reports from state and local health agencies (available

at https://github.com/nytimes/covid-19-data); and Johns Hopkins University Center for Systems Science and Engineering

(CSSE) (available at https://github.com/CSSEGISandData/COVID-19). Figure 1.2: Bureau of Labor Statistics (BLS), retrieved

from The Federal Reserve Economic Database (FRED) (IDs: PAYEMS, USCONS, MANEMP, USTPU, USINFO, USFIRE, USPBS,

USEHS, USSERV, USGOVT). Figure 1.3: U.S. Employment and Training Administration, retrieved from FRED (ID: ICSA). Figure

1.4: Moody’s, retrieved from Wharton Research Data Services (WRDS); Freddie Mac and Fed Board, retrieved from FRED (IDs:

MORTGAGE30US, DGS10). Figure 1.5: Bureau of Economic Analysis (BEA), retrieved from FRED (IDs: A091RC1Q027SBEA,

GDP). Figure 1.6: U.S. Treasury, retrieved from FRED (IDs: PCEPILFE, T5YIE, T10YIE). Figure 1.7: Datastream; BEA, retrieved from

FRED (IDs: GDPC1). Figure 1.8: BLS, retrieved from FRED (IDs: LNS12000089, LNS12000091). Figure 1.9: Datastream. Figure 1.10:

Datastream. Figure 1.11: Moody’s. Figure 1.12: Zillow. Figure 1.13: BEA, retrieved from FRED (ID: PSAVERT). Figure 1.14: Capital

IQ; Days of cash on hand is available cash relative to average daily operating expenses (cost of goods sold, Selling, General and

Administrative Expenses (SG&A); and interest expense) over the past 3 years (or 2 years, if only 2 years of data are available).

Figure 1.15: Moody’s, retrieved from WRDS; Datastream.

8 | U.S. SECURITIES AND EXCHANGE COMMISSION

Macro-Financial Overview

The macro-financial environment is encapsulated in three key aggregate drivers of financial

decisions: (1) economic fundamentals and growth; (2) monetary policy and the interest rate

trajectory; and (3) financial market signals and credit conditions.

Economic Fundamentals and Growth

Key Takeaway: Following the onset of the COVID-19 recession in March, the U.S.

unemployment rate increased to 14.7% in April 2020, and economic output declined

substantially. Employment then bounced back over the summer and GDP grew

substantially in 2020Q3. Likewise, consumption recently has exceeded pre-pandemic

levels, likely as consumers make up for missed consumption opportunities resulting from

pandemic-induced partial economic lockdowns; as the economy continues to rebound;

and as mortgage and broader interest rates have fallen, which has allowed households to lower their debt-service payments. Yet the recovery is starting from a notably

low base, several industries continue to face significant COVID-19-induced economic

distress, and consumer confidence is weak—though trending slightly upwards. GDP is

expected to grow steadily into 2021 but remain below its pre-pandemic trend.

The number of new confirmed COVID-19 cases peaked at over

450,000 per week in late July 2020 and then dropped to a weekly

rate of fewer than 250,000 by mid-September (Figure 2.1).

Similarly, newly reported deaths dropped to a rate near 5,000 per

week, after reaching more than 15,000 per week in mid-April. The

declining rate of new COVID-19 cases and deaths led policymakers

to partially reopen certain local economies. Although the number

of new deaths continues to hold steady, data as of November 13

show that the number of new confirmed COVID-19 cases has risen

to a weekly rate of more than 750,000. This uptick in new cases highlights the uncertainty over the path of

COVID-19 going forward, as the world waits for the distribution of COVID-19 vaccines, and has prompted

some local and state authorities to reverse or delay reopening protocols as a response.

To help combat the COVID-19 pandemic, local, state, and federal

U.S. policymakers issued stay-at-home guidelines for nonessential

workers and encouraged physical distancing. Although many

health experts argued that such actions were necessary for public

health, they severely limit everyday economic activities. Figure 2.2

plots real quarterly GDP dating back to the Great Recession (blue

line), as well as forecasted GDP for 2020Q3–2021Q1 (median

forecasts tabulated by MarketWatch; green line). Gray bars are

DERA ECONOMIC AND RISK OUTLOOK | 9

NBER recessions. While the U.S. economy was consistently expanding at a 2–3% annual rate

prior to the onset of COVID-19, during the first half of 2020 GDP fell 10.1% from its peak

in 2019Q4. In historical terms, a two-quarter GDP drop of this magnitude is unprecedented.

During the Great Recession of 2008–09, GDP from peak to trough fell only 4%. According

to the National Bureau of Economic Research (NBER) Business Cycle Dating Committee, the

peak in U.S. economic activity occurred in February 2020, and a recession began thereafter (See

NBER Announcement). Economic growth then surged in 2020Q3, and economic forecasters

expect steady growth in 2020Q4 and into 2021 (Figure 2.2; green line). Yet output is predicted

to remain below trend. Indeed, assuming that in the absence of the COVID-19 recession the U.S.

economy would have grown at a 2% annual rate (Figure 2.2; red line), the lost economic output

due to the COVID-19 outbreak just through 2020Q2 was $620 billion. If the path of GDP

follows analysts’ predictions (Figure 2.2; green line), by 2021Q1 lost economic output due to

COVID-19, compared to the 2% growth counterfactual, will reach $1.3 trillion.

As local economies continue to reopen, the severity of the COVID-19 economic damage will

hinge on how quickly the United States and its principal trading partners can resume normal

economic activity. Many factors will determine the time for recovery, including consumer

confidence and spending, firm failures, as well as behavioral changes that are a direct result of

the pandemic. Indeed, the resumption of economic activity will require a recommencement of

both supply and demand. As firms continue to restart production, households might be hesitant

to venture out to consume available output, while physical distancing practices may alter both

production and consumption patterns with cascading effects across various industries. For

example, as restaurants reopen, unless customers enter those establishments to “dine in” in the

same numbers or with the same frequency as before the slowdown, economic activity will not

match pre-COVID-19 levels. Similarly, an acceleration of remote work, for example, may move

production from urban clusters to suburban areas, with geographic implications for real estate

prices, local retail and restaurant spending, as well as travel and transportation. Nonetheless, the

United States registered robust economic growth at an annual rate of 33% in 2020Q3 and, as of

early November, economic forecasts collected by MarketWatch (see Figure 2.2) expect over 3%

annualized growth in both 2020Q4 and 2021Q1.

The sudden and unprecedented impact of the COVID-19 shock

immediately surfaced via the sharp rise in initial unemployment

claims, which reached over 6 million per week in late March and

early April (Figure 2.3). As local economies have reopened and

financial market stress has ameliorated, initial unemployment

claims have fallen to about 700,000 per week as of November 12

but remain above their pre-COVID-19 levels.

10 | U.S. SECURITIES AND EXCHANGE COMMISSION

The substantial number of initial jobless claims corresponded with

a large reduction in total employment and a higher unemployment

rate. Figure 2.4 shows that after non-farm U.S. payrolls peaked at

about 152 million in February 2020, the United States subsequently

lost over 22 million jobs during March and April. U.S. employment

rebounded sharply in May and exhibited further gains each month

through October, but non-farm payrolls remain 10 million off their

February peak. Following its historically low levels in 2019 and

early 2020, the unemployment rate jumped to 14.7% during April

as COVID-19-induced job losses mounted (Figure 2.5). As the

economy partially reopened in May and through the summer, the

unemployment rate has declined markedly to 6.9% as of October,

but that rate remains above pre-pandemic levels.

COVID-19 has also impacted industries

unevenly, as seen in Figure 2.6, which plots

the growth in employment by industry

from February 2020. The hardest hit

industries through October 2020 (red lines)

include the education and health services

(mostly due to employment declines in

education), traditional information (e.g.,

non-internet publishing, motion picture,

and non-internet broadcasting), leisure

and hospitality, and mining and logging

sectors. Employment growth in the leisure

and hospitality industry is especially bleak,

falling 50% with only a modest recovery

to date. Yet job losses in other sectors have

been substantially less severe. For example,

employment in the financial sector is just

slightly off its pre-pandemic highs.

Key Figure Takeaway: The COVID-19-induced recession

had the largest adverse impact on employment in the

education and health services, information, leisure and

As the number of those employed and the

hospitality, and mining and logging services industries.

number of those rendered unemployed differ

greatly across industries, each industry has

Figure Notes: Red lines denote the 5 industries with the lowest (most

a different weight in the computation of

negative) total employment growth from February to October 2020. Green

lines show the top performing industries in terms of total employment

U.S. total employment growth. Thus, the

growth from February to October, 2020. Data source: BLS, retrieved from

classification of U.S. total employment growth

FRED (IDs: PAYEMS, USMINE, USCONS, MANEMP, USWTRADE, USTRADE,

CES4300000001, USINFO, USFIRE, USPBS, USEHS, USLAH).

as a bottom performing category in Figure

2.6 (top-left panel) means that job losses were

highly concentrated in certain COVID-19 affected industries that employ a substantial number of people,

leading to larger employment declines for the United States overall than for the median industry.

DERA ECONOMIC AND RISK OUTLOOK | 11

The COVID-19 recession also lowered consumer confidence

and temporally stymied consumption. Figure 2.7 shows that the

consumer confidence index dropped from 130 in February 2020

to 90 in April 2020, a 35% decline in the wake of the onset of the

COVID-19 recession, with only a slight rebound through October.

Retail sales also sank approximately 25% during March and April

(Figure 2.8), likely because of declines in consumer confidence

(Figure 2.7) and as physical distancing limited on-site shopping.

Yet retail sales rebounded in May and then fully recovered to

pre-pandemic levels in June. Recent data through October show

that retail sales have exceeded their pre-pandemic trend. This

uptick may be related to households making up for past missed

consumption opportunities as economies reopen, the ongoing

economic recovery, a decline in mortgage and other interest rates

that reduce household monthly debt-service payments (Figure 1.4),

or a combination of these factors.

12 | U.S. SECURITIES AND EXCHANGE COMMISSION

Monetary Policy and Interest Rates

Key Takeaway: In the immediate aftermath of COVID-19-induced financial market distress, the

Fed lowered the target range for the fed funds rate to 0–0.25% and announced unlimited purchases

of Treasury securities and agency MBS. In addition, the Fed, in conjunction with the U.S. Treasury,

initiated various liquidity and purchasing facilities targeting corporate bonds, small- and mediumsized businesses, municipal securities, asset-backed securities (ABS), dollar swaps, commercial

paper, and repo markets, among others, to provide further monetary stimulus and battle market

illiquidity. Since the start of the pandemic, the size of the Fed’s balance sheet has grown over

$3 trillion, with U.S. Treasuries constituting the bulk of the purchases. More recently, the Fed announced it would pursue an “average inflation targeting” approach, wherein it would target an

average 2% inflation rate over time. However, inferred inflation expectations from Treasury markets

indicate that market participants expect inflation to remain below the Fed’s 2% target over both the

near- and medium-term. More broadly, and in line with accommodative monetary policy, the Treasury

yield curve suggests a low risk-free rate for the foreseeable future. At the height of COVID-19-induced

financial market distress, yields on a variety of lower rated debt instruments rose as default probabilities increased and market liquidity fell. Yet as credit conditions eased, yields across debt securities fell

and credit spreads have narrowed but in some cases remain higher than pre-pandemic levels.

As the COVID-19 pandemic unfolded, the Fed lowered the

fed funds rate to a target range of 0–0.25% by March 15,

2020. Figure 2.9 plots the recent path of the fed funds rate,

along with the expected fed funds rate as implied in futures

market prices. Futures traders expect the fed funds rate to

stay at its zero lower bound through 2022; hence, the Fed’s

monetary stance is expected to remain accommodative as

the economy recovers from the COVID-19 crisis. Indeed, in

Note: More information and term sheets

addition to large-scale asset purchases and a number of new

associated with the Fed’s extraordinary monetary

extraordinary monetary policy tools, Fed Chair Powell recently

policy actions can be found at https://www.

federalreserve.gov/newsevents/pressreleases/

announced that the Fed will target an average inflation rate

monetary20200323b.htm.

of 2% over time. The key justification for this announcement

For the most recent Fed press releases,

centers on monetary policy efficacy in the current environment

see https://www.federalreserve.gov/newsevents/

where both realized annual inflation and inflation expectations

pressreleases.htm.

have remained below the Fed’s 2% target (as discussed

below). Broadly, nominal interest rates–the interest rates typically quoted in the financial press and related

publications–are the sum of the equilibrium, real interest rate plus inflation. If inflation (expectations) remain

subdued, then nominal interest rates will naturally be low. In such a case, the Fed will have little room to

implement interest rate reductions during a downturn, limiting the potency of this key monetary policy tool.

Thus, targeting an average inflation rate of 2% is designed to allow the Fed more room to cut the fed funds

rate during times of economic stress before short-term rates bump up against their zero lower bound.

DERA ECONOMIC AND RISK OUTLOOK | 13

At the height of COVID-19-induced financial market distress in March, the Fed also announced

unlimited purchases of Treasuries and agency MBS (both commercial and residential). These

large-scale asset purchases coincided with the formation of numerous facilities. The Fed programs

include the establishment of facilities to support liquidity in various markets and target corporate

bonds and exchange-traded funds (ETFs) in the primary and secondary markets [those rated

BBB- (S&P); Baa3 (Moody’s) or higher, as of March 22, 2020, and BB- (S&P); Ba3 (Moody’s) at

the time of purchase]. The programs also target AAA-rated ABS that are backed by certain loans,

including student loans, auto loans, credit card loans, loans guaranteed by the Small Business

Administration (SBA), commercial mortgages, (leveraged) corporate loans through collateralized

loan obligations (CLOs), or related securities; money market funds; municipalities; and loans to

small- and medium-sized businesses. Fed measures also have consisted of dollar liquidity swap

lines with foreign central banks and lowering the primary credit rate to 0.25% to encourage

banks to borrow from the discount window.

Figure 2.10 shows the path of total Fed assets during the pandemic (blue line), as well as the

asset classes that constitute the largest share of Fed assets in crisis response. To provide historical

perspective, we also show data dating back to the Great Recession. From March 4, 2020,

through the most recent data in the sample, November 4, 2020, Fed total assets increased nearly

$3 trillion to over $7 trillion, a 70% gain. The bulk of this rise, consisting mostly of Treasury

purchases (purple line), central bank liquidity swaps (red line), and MBS purchases (gold line),

occurred in the immediate aftermath of COVID-19-induced financial market distress.

Figure 2.10 also highlights that

liquidity swaps (red line) are

primarily a crisis tool, with

Fed assets in liquidity swaps

rising at the height of financial

market distress. Liquidity

swaps with foreign central

banks, intended to provide

dollar liquidity to foreign

markets, are transactions where

foreign central banks sell their

Figure Data Source: Fed Board, retrieved from FRED (IDs: WALCL, TREAST,

WSHOMCB, WORAL, SWPT).

own currencies to the Fed for

dollars. As COVID-19-related

financial distress subsided in April and foreign central banks unwound their liquidity swap

positions, total Fed assets leveled off with increases in Fed holdings in other classes making

up the difference (e.g., Treasuries, MBS, and various new extraordinary programs).

14 | U.S. SECURITIES AND EXCHANGE COMMISSION

A key difference between the

COVID-19 monetary policy

response, relative to the Great

Recession, is the implementation

of new Fed liquidity facilities

and lending programs. Figure

2.11 plots Fed assets since the

start of the COVID-19 crisis

in a select number of these

programs. Some of the liquidity

facilities, such as the Money

Market Liquidity Facility,

increased market liquidity at

the height of COVID-19Figure Data Source: Fed Board, retrieved from FRED (IDs: H41RESPPAAC2HANWW,

H41RESPPAAC2HNWW, H41RESPPAADHNWW, H41RESPPAAENWW,

induced financial market

H41RESPPALDBNWW, H41RESPPALDJNWW).

distress, while others, such as

the Payroll Protection Program and the Main Street Lending Facility, appear to represent longer

term monetary stimulus. An interesting feature across all of these programs is that they represent

a relatively small share of Fed total assets. Indeed, notice that the vertical axis in Figure 2.11 is in

billions of dollars, whereas Figure 2.10 is in trillions. However, large purchases or lending are not

necessarily required for these programs to have large market effects; for example, New York Fed

research indicates that the mere announcement of Fed liquidity facilities had a substantial impact

on borrowing costs and market behavior in the commercial paper market, in the corporate bond

market, on money market funds, and in the municipal bond markets.

DERA ECONOMIC AND RISK OUTLOOK | 15

Despite the Fed stimulus, inflation plummeted during the COVID-19-induced economic distress.

To provide historical context, Figure 2.12A shows that the core inflation rate rarely reached the

Fed’s symmetric 2% inflation target over the last decade, with the annual inflation rate falling

to 1% in April 2020. Inflation has since rebounded, but remains below the Fed’s 2% inflation

target. Figure 2.12B plots inflation expectations over the next 5 and 10 years from a given

point in time computed from Treasury nominal and inflation-protected securities. The graph

documents that prior to the crisis, the expected inflation rate typically fluctuated between 1.3%

and 2.1%. However, with the onset of the pandemic, inflation expectations sank; in April 2020,

market participants had expected an average annual inflation rate below 1% over the following

5 years. Since then, expected inflation has rebounded somewhat, but the anticipated annual

inflation rate over the next 10 years still remains well below the Fed’s 2% target.

Key Figure Takeaway: Following the COVID-19 outbreak, inflation declined sharply. Since then,

inflation and inflation expectations have recovered but remain below the Fed’s 2% inflation target.

Figure Data Source and Notes: U.S. Treasury, retrieved from FRED (IDs: PCEPILFE, T5YIE, T10YIE). Breakeven inflation rates are

computed from Treasury Inflation-Protected Securities (TIPS) and Nominal Treasury Securities.

The dramatic decline in economic

activity after the COVID-19 outbreak,

the Fed’s large monetary stimulus,

and diminished inflation expectations,

coupled with perhaps an elevated

demand for U.S. Treasury securities,

collectively presage exceptionally low

U.S. Treasury interest rates. Figure

2.13 plots the current yield curve for

U.S. Treasury securities (blue line)

versus its average over the past 10

years (red line) by maturity horizon.

Not only are rates historically low at

the short end of the yield curve (e.g., for

short-term securities), but they are also

Figure Notes: The blue line is the current Treasury yield curve; the red line

represents the past 10-year average, computed by taking the mean by each

maturity date. For more on Term Premia, see newyorkfed.org/research/data_

indicators/term_premia.html.

Figure Data Source: U.S. Treasury, retrieved from FRED (IDs: DGS1MO, DGS3MO,

DGS6MO, DGS1, DGS2, DGS3, DGS5, DGS7, DGS10).

16 | U.S. SECURITIES AND EXCHANGE COMMISSION

low for longer maturities. Long-term yields comprise the current short-term rate plus the sum of

market participants’ expectations of future interest rate changes, as well as a term premium (the

additional interest that investors demand in exchange for being locked into a longer term bond

rather than just continuously investing in short-term bonds). The relatively flat current yield

curve suggests that the term premium and investors’ expectations of future interest rate increases

are low.

Although Treasury yields have fallen to historic lows, interest rates

on other assets have not all experienced comparable declines. The

likely reason is that credit risk has risen because of diminished

economic activity, especially in certain sectors, following the

slowdown. Figure 2.14 documents that yields on Baa-rated

corporate bonds increased beginning in late March, likely because

of elevated default probabilities. From there, Baa yields fell as

market credit conditions loosened and the Fed, along with the

Treasury, announced the establishment of corporate credit liquidity

facilities. Yet the spread between Baa yields and Treasuries remains

greater than pre-pandemic levels, congruent with lingering credit

risks. In comparison, Figure 2.15 plots the average 30-year U.S.

mortgage rate and its spread relative to the 10-year Treasury. The

30-year mortgage rate has declined from about 3.5% in midFebruary to just 2.8% as of November 8, 2020.

Mortgage rates represent a key link between financial markets and the real economy, as a decline

in mortgage rates spurs mortgage refinance and purchase activity that often translates into durable

consumption purchases and follow-on real economic activity. Indeed, current low mortgage rates

correlate with elevated retail spending (Figure 2.8).

DERA ECONOMIC AND RISK OUTLOOK | 17

Financial Market Signals

Key Takeaway: In mid-March 2020, at the peak of COVID-19 financial market distress,

the VIX equity market volatility and uncertainty index (VIX) reached levels last

seen during the Great Recession of 2008-09. The VIX has retreated since then

but remains at elevated levels. Similarly, the corporate default spread (Baa – Aaa

yields), a broad credit market risk proxy, rose sharply before trending downwards

beginning in mid-April, as credit conditions eased. Yet the corporate default spread

remains above its pre-COVID-19 levels. The corresponding higher interest rates for

lower rated bonds reflect higher expected default probabilities from the perspective

of bond market investors, but also perhaps market liquidity. Indeed, credit ratings

downgrades increased substantially in March 2020, but the pace of downgrades has

slowed and returned to pre-pandemic levels as financial market stress has eased.

The impact of the COVID19 pandemic on financial

markets is apparent in the

path of the VIX. During

the height of COVID-19induced financial market

distress in mid-March,

the VIX reached values

around 80, corresponding

Key Figure Takeaway: The VIX reached levels last seen during

to historical highs last seen

the Great Recession, suggesting high levels of uncertainty over

during the Great Recession

expected economic output and firm profits, but recently it has

(Figure 2.16A). These peak

retreated somewhat.

VIX realizations signaled

Figure Data Source: Chicago Board Options Exchange, retrieved from FRED (ID: VIXCLS).

extreme investor uncertainty

about firms’ future profits and economic output related to the COVID-19 recession. Recently,

uncertainty proxied by the VIX has retreated (Figure 2.16B), owing to fiscal and monetary

stimulus, the broad-based recovery in the economy and financial markets, as well as hopes that

the total duration of the COVID-19 pandemic might not be too long. However, current VIX

realizations are higher than pre-pandemic values, suggesting that material uncertainties remain.

18 | U.S. SECURITIES AND EXCHANGE COMMISSION

Figure 2.17 plots the

corporate default spread, Baa

– Aaa corporate bond yields,

an aggregate proxy of credit

risk in the corporate bond

market. After the onset of the

COVID-19 crisis, corporate

default spreads rose sharply

in March, meaning that yields

Key Figure Takeaway: The corporate default spread (Baa

on lower rated corporate debt

– Aaa corporate bond yields) increased in the wake of

increased relative to those

COVID-19-induced financial market distress but did not

on higher rated bonds. This

reach levels seen during the Great Recession. Recently, the

widening credit spread was

corporate default spread has retreated but remains above

due largely to increased default

its pre-pandemic levels.

probabilities on lower rated

Figure Data Source: Moody’s, retrieved from WRDS.

corporate debt. Specifically,

as economic activity faltered with the COVID-19 slowdown, investors feared that various income

streams might dry up and firms might find it difficult to refinance their debt obligations. These factors

make debt service difficult and costly, boosting the likelihood that a borrower may miss a payment and

subsequently default.

Figure 2.17A also shows that while the recent rise in the corporate default spread is notable, the

elevated values in March and mid-April were well below those seen during the Great Recession and

perhaps suggest credit markets were less strained than in 2008-09. Figure 2.17B plots the recent

path of the corporate default spread. Like the VIX (Figure 2.16B), the corporate default spread fell

in mid-April. This trend reversal in the corporate default spread tracks various Fed announcements

about the establishment of liquidity facilities, suggesting that credit conditions ameliorated with Fed

actions along with a broader reduction of financial market stress. Yet Figure 2.17B also shows that the

corporate default spread remains above pre-COVID-19 levels and, thus, material credit risks or material

uncertainties may persist. Indeed, investors may expect lower rated corporate borrowers to struggle to

service and repay debt in the upcoming months, relative to higher rated borrowers, as the economic

fallout from the COVID-19 recession unfolds.

DERA ECONOMIC AND RISK OUTLOOK | 19

The economic downturn has affected credit ratings that reflect

long-term views on the credit quality of fixed income instruments

(rating through the cycle). Credit rating agencies, which are

important intermediaries in providing information in securities

markets, started to change their views in March 2020, in response

to rapidly changing economic conditions. As recently as February

2020, rating agencies anticipated a modest slowdown with a low

recession likelihood. However, the events of March 2020 changed

their views. As shown in Figure 2.18, rating agencies lowered U.S. corporate debt issuers’ ratings

at a rapid clip following COVID-19-induced financial market distress. As credit conditions

improved, the pace of downgrades slowed and returned to pre-pandemic levels.

Data Sources Not Previously Mentioned: Figure 2.4: BLS, retrieved from FRED (ID: PAYEMS). Figure 2.5: BLS, retrieved from

FRED (ID: UNRATE); Figure 2.7: Datastream. Figure 2.8: FRED, retrieved from FRED (ID: RRSFS). Figure 2.9: Datastream; Fed

Board, retrieved from FRED (ID: FEDFUNDS). Figure 2.18: Refinitiv DataScope.

20 | U.S. SECURITIES AND EXCHANGE COMMISSION

Market Segments

The U.S. Securities and Exchange Commission’s mission is to protect investors, maintain

fair, orderly, and efficient markets, and facilitate capital formation. Below we examine the

underpinnings of economic growth through the lens of these three mission areas and study

(1) markets; (2) investors; and (3) borrowers, securities issuers, and other entities that raise

capital. The chart below illustrates the interlinkages between these three segments.

Markets

Key Takeaway: Because of the COVID-19 pandemic, key equity indices plunged between

30-40% from January to March 2020. Investor expectations of weak corporate earnings

following the COVID-19-induced economic slowdown likely led to this fall in equity prices.

Then the S&P 500 nearly completely recovered from March lows, while indices of smaller

companies have underperformed. Deviations in equity market performance between the

S&P 500 and smaller firms occurred mostly in the immediate wake of pandemic-induced

financial market distress. In fixed income markets, AAA-rated corporate securities have

outperformed other lower rated bonds, where the yields on AAA-rated securities are

below their pre-pandemic levels. Yields on non-investment grade debt climbed substantially during the period of COVID-19-induced financial market distress, likely reflecting

investor concerns over increased default probabilities, but also perhaps market illiquidity.

Recently, yields on these lower rated securities have also fallen.

Asset Values

After a historically long bull market, equity market prices fell

sharply in the immediate wake of the COVID-19-induced economic

slowdown. Figure 3.1 plots equity returns from January 2020 for

the S&P 500 and the Russell 2000, an equity index of smaller

companies. Both the S&P 500 and the Russell 2000 fell in late

February as investors increasingly anticipated a decline in economic

activity that would ultimately depress corporate profits. Thus,

valuations as measured by the cyclically adjusted price-to-earnings

ratio (CAPE) fell relative to historical earnings but remained higher

than they were at the depths of the Great Recession (Figure 3.2). By

mid-March, the S&P 500 had fallen over 30%. In comparison, the

DERA ECONOMIC AND RISK OUTLOOK | 21

Russell 2000 had declined nearly 40%, coinciding with COVID-19’s likely outsized impact on the often

more volatile income and revenue streams of smaller companies. By July, the S&P 500 had nearly fully

recovered from its earlier lows, while the Russell 2000 has only recently reached its pre-pandemic levels.

Figure 3.3 proxies COVID-19 equity market impacts by sector, using ETF returns from February 10 to

November 11, 2020. The hardest hit sectors over this time period (red lines) include the energy, financial,

real estate (REITs), transportation, and utility sectors. The energy sector has faced large demand declines

in the aftermath of the pandemic, while oil firms have been further impacted by increased price and

supply competition. Financial companies are facing uncertainty related to borrower debt service, the

ability to generate new business in the wake of COVID-19-induced economic distress, and the Federal

Reserve mandated dividend and share buyback restrictions intended to boost bank capital. Likewise,

physical distancing is directly reducing travel and transportation across the country. In contrast, physical

distancing and remote work have benefited companies in several sectors, such as online retail and

technology. Indeed, ETF prices for these sectors have recovered to at least their pre-pandemic levels, with

an online retail ETF gaining more than 80% from aggregate market highs in February 2020. Likewise,

retail firms have also outperformed, with retail sales returning to pre-pandemic levels (Figure 2.8).

Figure Notes: Red lines are the five industries with the lowest (most negative) returns from February 10 to November 11, 2020.

Green lines are the top performing industries in terms of returns from February 10 to November 11, 2020. Data source: Datastream.

22 | U.S. SECURITIES AND EXCHANGE COMMISSION

For fixed income markets, Figure 3.4 displays total bond market returns and yields by credit

rating. First, Figure 3.4A shows that bonds across asset classes have appreciated considerably

since 2010. In particular, lower rated B and CCC (or lower) bonds nearly doubled in value before

the COVID-19 outbreak. However, lower rated bond prices are more volatile, as seen by the

large drops in late 2011, 2016, 2018, and, most recently, in 2020. Because of an expected decline

in economic activity due to the COVID-19 slowdown and thus increasing credit risk concerns

and default probabilities, total returns on the lower rated B and CCC bonds fell between 15%

and 25% by mid-March (Figure 3.4B). These credit risk concerns likely outweighed a broader

decline in the risk-free interest rate (e.g., U.S. Treasuries). Indeed, the poor returns for lower rated

securities through March coincided with a spike in yields (Figures 3.4C and 3.4D) that began

to abate in April 2020. Since then, risk-free interest rates have fallen (Figures 1.4 and 2.13), and

bond market conditions have eased considerably. Hence, yields across rating categories have

returned to or fallen below their pre-pandemic levels (Figure 3.4D), as bond return indices have

marched upwards (Figure 3.4B). The highest rated AAA bonds, in particular, have outperformed

over the course of the COVID-19 crisis and, as of November 11, their yields were approximately

one percentage point below their pre-COVID-19 levels in early January 2020.

DERA ECONOMIC AND RISK OUTLOOK | 23

Mutual Fund, ETF and Money Market Fund Investors

Key Takeaway: With COVID-19-induced financial market volatility in March 2020, investors increasingly moved assets away from bond and equity market investments, including

those held through mutual funds and ETFs, and into assets like cash and money market

funds backed by U.S. government agency or Treasury securities beginning in March

2020. Then, as credit conditions eased and the Fed implemented unprecedented monetary stimulus, investments returned, particularly in taxable bond funds. Total net fund

flows into taxable bond funds have exceeded $280 billion as of November 4, 2020.

Figure 3.5 presents weekly

net fund flows into select

classes of mutual funds and

ETFs from January 7 to

November 4, 2020. Prior to

the COVID-19 pandemic,

there were substantial fund

inflows into taxable and

municipal bond funds,

outflows from domestic

equity funds, and slight

inflows into commodity

funds. Then as the COVID19 pandemic unfolded and

the corresponding economic

slowdown became imminent,

investors, in net, redeemed assets

from both bond and domestic

equity markets.

Key Figure Takeaway: Both equity and bond funds

experienced outflows following COVID-19-induced financial

market distress. However, capital flowed back into funds,

particularly taxable bond funds–which had seen the most

significant decrease–as credit conditions eased and the Fed

expanded its various monetary policy and liquidity programs.

Figure Data Source: Investment Company Institute (ICI), retrieved from Datastream.

Taxable bonds include, for example, corporate bonds. ETFs sell large blocks of shares to,

and only redeem them in large blocks from, authorized participants, who may transact

on their own behalf or act as agent for others, while individual ETF shares trade on the

secondary market.

Data Sources not previously mentioned: : Figure 3.1: Datastream. Figure 3.2: Datastream. Figure 3.3: Datastream.

Figure 3.4: Ice Data Indices, LLC, retrieved from FRED (IDs: BAMLCC0A1AAATRIV, BAMLCC0A3ATRIV, BAMLCC0A4BBBTRIV,

BAMLHYH0A1BBTRIV, BAMLHYH0A2BTRIV, BAMLHYH0A3CMTRIV, BAMLC0A1CAAAEY, BAMLC0A3CAEY,

BAMLC0A4CBBBEY, BAMLH0A1HYBBEY, BAMLH0A2HYBEY, BAMLH0A3HYCEY.

24 | U.S. SECURITIES AND EXCHANGE COMMISSION

Net withdrawals from equity funds following the COVID-19 pandemic extended a longer term

trend. This trend may be related to media reports of increased direct investment activity by retail

investors in equities. In contrast, taxable bond funds experienced sizable inflows until late February 2020. Then, investors withdrew nearly $300 billion from taxable bond funds, as default

probabilities increased for lower rated bonds and as investors may have sought to increase their

cash positions. Investors’ preference to move assets away from this market may have resulted in

their selling bonds held directly. Outflows may have also indirectly prompted funds to sell assets

in response to redemption requests. This trend, however, reversed beginning in April as credit

market stress attenuated and as the Fed, in conjunction with the Treasury, announced the establishment of corporate bond liquidity facilities. Indeed, net fund flows into taxable bond funds

increased by over $400 billion from mid-April to October 2020. A similar, albeit muted, trend

occurred in municipal bond funds.

Money Market Funds

A money market fund (MMF)

is a type of mutual fund that

invests in short-term, high quality

debt securities. Based on investments of the fund, MMFs can be

defined as government, prime,

and municipal (or tax exempt).

The COVID-19 financial market dislocation in mid-March

resulted in significant redemptions from some prime and taxexempt MMFs, while Treasury

and government agency MMFs

Key Figure Takeaway: Since May 2020, assets under

experienced large inflows (Figure 3.6).

management of the MMF industry have been gradually

The assets under management of the

declining.

MMF industry reached an all-time

high of $5.2 trillion at the end of May.

Figure Data Source: Crane Data (Daily Data). Data Notes: Some fund families

report their fund flows to CraneData on a less frequent basis potentially resulting

Since then, the MMF industry assets

in a temporary distortion of daily series.

have steadily declined reaching $4.8

Other Notes: Prime MMFs can invest in a broad range of short-term, high quality

trillion as of October, but still sigassets such as U.S. Treasury bills, federal agency notes, certificates of deposit,

nificantly higher than the $4.0 trillion

corporate commercial paper, repurchase agreements, and obligations of states,

pre-pandemic level seen in February. For cities, or other types of municipal agencies. Government MMFs invest 99.5% or

more of their total assets in short-term Treasury securities, securities issued by

a more in depth look at MMFs, see the

governmental agencies, repurchase agreements backed by these securities, or cash.

Research Spotlight, “The Commercial

Paper Market and Money Market Funds.”

DERA ECONOMIC AND RISK OUTLOOK | 25

Borrowers, Securities Issuers, and Capital Formation

Key Takeaway: U.S. firms have raised record amounts of capital in public markets in

2020, especially during the 2nd quarter when the economic uncertainty surrounding

the COVID-19 response was highest. The public firms that raised the most capital

had high credit ratings, growing inventory and receivables, and positive profitability

growth. Firms used the capital raised to increase cash balances and also to invest,

including in acquisitions. Firms increased cash balances more when they had declining

inventory and receivables (both likely sources of additional cash) and a dip in profitability,

despite these firms’ relative disadvantage in capital raising.

How much capital did U.S. firms raise, and how did they raise it?

Corporate borrowers issued $2.2 trillion of fixed income securities and $340 billion of equity

securities in U.S. markets over January-November 2020.1 The volume of fixed income issuance is

the highest for any year since at least 1996 (2nd place is 2017 with $1.7 trillion in 2020 dollars).

The volume of equity issuance is the highest since 2000, when issuance was $457.5 billion in

2020 dollars.

We analyze $1.6 trillion of fixed income issuance and $265 billion of equity issuance by U.S. public firms, from January to October 2020, using data from S&P’s Capital IQ. The Capital IQ data

also include $80 billion of bank loan issuance during the same period. Figure 3.7a graphs the total

amount of capital raised, with issues broken down into several subgroups by issuer characteristic.

The first set of bars shows that firms with investment grade (IG) ratings raised much more capital

than firms with high-yield (HY) ratings or no rating (NR), and that IG firms mostly raised capital

in bond markets. HY and especially NR firms relied much more heavily on equity markets and on

banks. The next three pairs of columns separate observations based on whether the issuer’s inventory, receivables, or operating profitability had increased year over year, as of the quarter prior to

the security issuance. Inventory is scaled by assets, receivables are scaled by sales, and operating

profitability equals [revenues – cost of goods sold – selling, general, and administrative expenses –

interest expense] scaled by assets.

These bars indicate that firms with growing inventory and firms that increasingly extended trade

credit to customers were more active in public securities markets. Firms with growing profitability

also raised slightly more capital (the final pair of bars). One reason why IG firms outpaced HY

and NR firms in terms of security issuance is that IG firms tend to be larger. However, a different

picture emerges in Figure 3.7b, which scales each debt or equity issuance by the issuer’s assets and

displays the medians for the same subgroups used in Figure 3.7a. Though debt and equity issues

from NR and HY firms were smaller than issues from IG firms in aggregate, they were much

larger as a percentage of the issuing firms’ assets. The yellow bars in Figure 3.7b are also much

larger than those in Figure 3.7a, indicating that smaller firms were relatively more active in equity

markets—even among the subgroup of firms with IG ratings.

1

See SIFMA Statistics, December 2020.

26 | U.S. SECURITIES AND EXCHANGE COMMISSION

Firms can raise capital in

public equity markets in

three basic ways. The first is

through a traditional IPO.

Firms that are already public

can return to the equity markets to sell additional shares in

a “seasoned equity offering”

(SEO). Finally, a private firm

can transition to a publicly

traded company through a

de-SPAC transaction with a

special purpose acquisition

company (“SPAC”), a type of

blank check company that has

previously raised public equity

in its own IPO.

Figure 3.8 charts the volume of capital raised by U.S. public firms through these methods.

IPO and SEO data are from Capital IQ and data on de-SPAC transactions are from PrivateRaise. This figure shows a very large spike in SEOs in June and July of 2020, as firms raised

cash. IPO activity was also relatively high in June and July, dipped slightly in August, and

then continued to trend upward. The volume of closed or announced de-SPAC transactions

was very high in 2020Q3, and in September 2020 it reached its highest level ever.

DERA ECONOMIC AND RISK OUTLOOK | 27

What did U.S. firms do with capital raised?

Two important motivations for raising capital are investment and precautionary cash savings, and

U.S. firms appear to have used the capital they raised in 2020 for both purposes. Figure 3.9 plots

the percentage growth in cash (cash divided by assets), rate of capital investment (capital expenditures divided by assets at the end of the previous quarter), R&D expenses, and SG&A expenses2

for two groups of firms from 2020Q1 to 2020Q3—those that raised capital and those that did

not. Firms that raised capital in some quarters but not in others during may appear in each group

at different times. Growth rates of Cash, R&D, and SG&A are percentage changes over the previous four quarters. To address the possibility that capital expenditures are “lumpy,” or not evenly

spaced over time, Capex growth in this figure is the capital investment rate divided by the average

capital investment rate across the previous 20 quarters.

This figure shows that firms raising capital increased their

cash balances much more than firms that did not raise

capital in a given quarter, and they also increased spending on

R&D and SG&A at a higher pace. Despite the large drop in

the investment rate for both groups in 2020, firms that raised

capital decreased their investment rate by a smaller amount.

Another possible use of capital is for investor payouts, particularly through share repurchases. We do not observe any

meaningful differences in either gross or net share repurchases

between firms that raised capital in 2020 and those that

did not. Though the firms raising capital ought to have greater Data Source: Capital IQ

resources available to distribute to investors, it appears that motivations to invest and to stockpile

cash outweighed motivations to fund investor payouts.

A further analysis of

firms’ cash management during 2020

reveals additional likely

sources of cash and

likely motivations for

raising cash. Figure

3.10 graphs firm-level

changes (year over year)

in cash as a percent

of total assets as of

2020Q3.

2 SG&A is formally treated as an expense, but some components of SG&A are economically more similar to investment than

overhead—e.g., website development, spending on I.T. systems, employee training, restructuring charges. Recent academic

studies on corporate investment and intangible capital include SG&A—see, e.g., Peters and Taylor (2017) Intangible Capital

and the Investment-q Relation, Journal of Financial Economics 123, 251-272. See also Eisfeldt and Papanikolaou (2014) The

Value and Ownership of Intangible Capital, American Economic Review: Papers and Proceedings 104, 1-8.

28 | U.S. SECURITIES AND EXCHANGE COMMISSION

The first subgraph separates firms based on whether or not they raised any capital in public

markets in 2020. The second subgraph splits firms into IG, HY, and NR rating categories. The

last three subgraphs separate firms into categories based on whether Inventory (inventory/assets),

Receivables (accounts receivable/sales), or Profitability (operating profits/assets) was lower or

higher in 2020Q3 than in 2019Q3.

This figure aligns with Figure 3.9 in showing greater increases in cash for firms that raised capital

in debt or equity markets. The largest cash increases occurred among HY firms, possibly because

their demand for precautionary cash was greater than for IG firms but their ability to raise capital

was greater than for NR firms. Research3 finds that declines in inventory and in receivables help

explain changes in U.S. firms’ cash balances, and this figure supports those findings. There are two

reasons why inventory and receivables should correlate with cash balances. The first is mechanical: inventory falls when firms do not incur the expense of replacing inventory and receivables fall

when firms more aggressively collect from their customers. The second reason is that low inventories and receivables (less credit extended to customers) may be a temporary response to financial

stress, leading to a higher demand for cash against the future expenses that will be needed to

replenish inventory and reestablish normal sales terms with customers.

Low profitability may indicate financial stress and greater demand for precautionary savings, but

it may also indicate relative inability to retain cash from operations. It is unclear, then, whether

profitability ought to be positively or negatively related to firms’ cash holdings in 2020. Figure

3.10 shows that firms whose profitability was lower in 2020Q3 than in 2019Q3 stockpiled

slightly more cash over the same period.

Were asset sales/acquisitions a source or a use of cash?

Acquisition activity can also potentially be a source of cash for firms selling assets or a use of

cash for firms acquiring assets. Figure 3.11 graphs the volume of M&A transactions during 2020

(top two graphs) and the average ratio of the transaction amount to the seller’s or buyer’s assets

(bottom two graphs), for all transactions where data are available. Sellers (left graphs) and buyers

(right graphs) are further divided into groups based on median firm Days Cash, or the ratio of

cash and liquid securities to average operating expenses over the previous 3 years. Days Cash

refers to the value as of the last quarter before the M&A announcement date. The data include

405 transactions where the seller was a U.S. public firm and 1,144 transactions where the buyer

was a public U.S. firm. All transactions data and firm financial data are from Capital IQ.

3 See Bates, Kahle and Stulz (2009) Why do U.S. Firms Hold So Much More cash than They Used To? Journal of Finance 64,

1985-2021.

DERA ECONOMIC AND RISK OUTLOOK | 29

The top-left graph shows that among all sellers in M&A transactions, sellers with high Days

Cash sold slightly more assets overall, and the bottom-left graph shows that sellers with high and

low Days Cash were comparable in the relative size of assets sold. The top-right graph shows

that buyers with high Days Cash acquired much more assets overall, and the bottom-right graph

shows that they also bought much larger assets as a percentage of buyer size. Overall, firms with

large cash balances appear to have used some of that capital for acquisitions, but firms with low

cash balances were not more likely to sell assets.

The COVID-19 pandemic and the associated restrictions on economic activity led to

heightened uncertainty and greater demand for cash, and corporations may have also been

enticed by historically low interest rates and elevated equity valuations during much of the year.

Firms with strong fundamentals raised capital in debt and equity markets, and used it to boost

cash balances and also to invest—including investments in R&D, SG&A, and acquisitions. Firms

with weaker fundamentals raised less capital in public markets but retained a higher percentage

of the capital raised as cash. Firms additionally raised cash in 2020 by allowing inventory and

receivables balances to fall.

30 | U.S. SECURITIES AND EXCHANGE COMMISSION

Spotlights

The Commercial Paper Market and Money

Market Funds

Viktoria Baklanova, Igor Kozhanov, Isaac Kuznits, Trevor Tatum

Key Takeaways

The uncertainty and market volatility from the COVID-19 economic shock caused an unexpected

increase in demand for cash and short-dated U.S. government securities leading to asset redemptions

from certain types of money market funds (MMFs) and disrupting issuance of credit-related

instruments. This disruption resulted in significantly constrained liquidity and higher funding costs. In

particular, conditions in the commercial paper (CP) market began to deteriorate rapidly in the second

week of March, when spreads of AA-rated nonfinancial CP reached new historical highs, while spreads

for AA-rated financial CP widened to the highest levels since the 2007-2008 financial crisis.

As part of the general deterioration in market conditions, some prime and tax-exempt MMFs

experienced heavy redemptions beginning in the second week of March 2020.4 Outflows from

these funds abated quickly after the Federal Reserve’s announcement of its support for the short

term funding markets, including support for the CP issuers and MMFs in mid-March.

U.S. Short-Term Funding Market

A well-functioning short-term funding market (STFM) is critical to the real economy and to the

broader capital markets. The U.S. STFM encompasses many types of participants and market

sectors, which are themselves interconnected outside the STFM. Figure 4.1 shows various STFM

market participants, their relative size, and their interconnections as of 2020-Q2, three months after

the peak of the COVID-19-induced economic shock and distress in the financial markets in spring.5

A few observations are in order. The STFM contains many sub-markets (e.g., repo financing and

CP) and several types of participants are central for orderly market functioning, such as brokerdealers. Some categories of participants, such as non-financial corporates or state and local

governments, can participate as both short-term borrowers and short-term lenders.

The STFM has changed significantly since the pre-COVID-19 period. The most pronounced

change in the STFM between the last quarter of 2019 and the middle of 2020 is the increased

footprint of the federal government, which increased T-bill issuance used by many STFM

participants. In turn, MMFs, primarily government MMFs, increased their holdings of Treasury

securities three-fold from $0.6 trillion to $1.9 trillion.6

4 Prime MMFs can invest in a broad range of short-term, high quality assets such as U.S. Treasury bills, federal agency notes,

certificates of deposit, corporate commercial paper, repurchase agreements, and obligations of states, cities, or other types

of municipal agencies.

5 The state of the STFM as of 2019-Q4 and the effects of the COVID-19 economic shock were discussed, among many other

things, in the SEC staff report entitled “U.S. Credit Markets: Interconnectedness and the Effects of the COVID-19 Economic

Shock.” Figure 5.1 updates Figure 2.1 from that report.

6 Government MMFs invest 99.5% or more of their total assets in short-term Treasury securities, securities issued by governmental agencies, repurchase agreements backed by these securities, or cash.

DERA ECONOMIC AND RISK OUTLOOK | 31

Relatedly, holdings of MMF shares by households increased from $2.1 trillion to $2.6 trillion and

by non-financial corporate businesses from $577 billion to $962 billion.

In addition, non-financial corporate businesses increased their holdings of other cash and short-term

financial instruments: cash and checkable deposits balances increased from $1.27 trillion to $1.77

trillion, while time and savings deposits increased from $200 billion to $300 billion. Overall, nonfinancial corporate businesses hold close to $1 trillion cash and short-term financial instruments,

more than at the end of 2019, according to the Financial Accounts of the United States. Nonfinancial corporate holdings of commercial paper (CP) have not changed over the same period.

In this Spotlight, we discuss the CP market and the evolving role of prime MMFs.7

This figure shows borrowers on the left and lenders on the right, so that credit risk flows from

left to right and money flows from right to left. The width of the bands represents outstanding

credit as of the end of 2020-Q2 ($1 trillion shown at bottom right for scale). Data sources and

other technical details are in the SEC staff report U.S. Credit Markets: Interconnectedness and

the Effects of the COVID-19 Economic Shock. The figure does not include securities lending and

prime brokerage activity because of the lack of reliable disaggregated (and in some cases, reliable

aggregated) data. The figure also nets some repo connections for simplicity.

7 A large part of this Spotlight was published on November 9, 2020, as a separate report entitled “Primer: Money Market

Funds and the Commercial Paper Market” on the website of the Division of Investment Management’s Analytics Office.

32 | U.S. SECURITIES AND EXCHANGE COMMISSION

U.S. Commercial Paper Market

CP is unsecured, short-term debt issued for a specified amount

to be paid at a specified date. CPs are issued at a discount, with

minimum denominations of $100,000 and terms normally ranging

from 1 to 270 days.

Total U.S. CP outstanding was at $1,007 billion at the end of

June 2020, down by $37 billion since the end of 2019 (Figure 5.2).

This is around one half of $2.2 trillion, the all-time high in CP

outstanding reached in July 2007. The majority of the decline in

CP outstanding since the financial crisis can be attributed to

reduction in the asset-backed commercial paper (ABCP) issuance.

As of June 2020, ABCP outstanding were at $214 billion

accounting for 21% of the total CP outstanding (Figure 4.2). CP

issued by U.S. financial firms were at $189 billion (or 19% of the

total); CP issued by nonfinancial firms were at $166 billion (or

17% of the total); and non-U.S. financial and other firms were at

$438 billion (or 43% of the total).

Many types of institutional investors participate in the CP market,

including investment companies, retirement accounts, state and

local governments, financial and nonfinancial firms. As of June

2020, nonfinancial firms were the largest investors accounting for

25% of the total CP market followed by MMFs at 22% (Figure

4.3). Investments by financial firms were at 19% of the total.

Other large CP investors are mutual funds (ex-MMFs) at 10%, state and local governments at 7%

and pension accounts at 5%. The “Others” category includes smaller CP investors that collectively

account for around 13% of the total CP outstanding.

The investor base in the CP market has changed over time. For

example, MMFs used to account for a substantially larger share of

the CP market at close to 47% in September 2001. Over the last 20

years, MMF participation in the CP market has declined markedly.

One reason for the decline is that assets under management in

government MMFs, which do not invest in the CP market, have

grown, while assets in prime MMFs have declined, resulting in

lower demand for CP from MMFs (Figure 4.4). On the other

hand, CP investments of nonfinancial corporations have increased

almost six-fold since 2000 to $250 billion in June 2020 (or 25% of

the total CP market) from $46 billion in March 2000 (or 3% of the

total CP market).

DERA ECONOMIC AND RISK OUTLOOK | 33

What happened in the CP market in mid-March 2020?

In mid-March 2020, CP rates increased, which is normally

associated with a lack of investor demand (Figure 4.5), and

became significantly more volatile, which is normally associated

with elevated economic uncertainty. However, the broad scope

of market developments at the onset of the COVID-19 pandemic

complicates the attribution analysis. Corporate investors in the

CP market may have reduced their allocations in anticipation

of reduction in revenues. MMFs and mutual funds may have

decreased their CP investments in anticipation of investor

redemptions. Form N-MFP data show that prime MMFs, in

particular, reduced their holdings of longer-dated CP. They did it to

keep their buffers of weekly liquid assets (WLA) above 30% and

were likely reluctant to purchase assets with maturities of more

than seven days that would not qualify as WLA.8 This, in turn, limited ability of some CP issuers

to issue longer-dated CP. Available data show that prime MMFs and short-term and ultra-short

corporate bond mutual funds experienced significant outflows in March (Figures 4.6 and 4.7).

Prime MMFs lost around 11% of their net assets in March. Similarly, short-term and ultra-short

bond mutual funds lost around 10% of their assets.

At the same time, some CP issuers may have turned to the CP market to bridge their funding needs.

Overall, the CP outstanding increased in the first quarter of 2020 by $44 billion, despite the spike

in the CP rates. During the second quarter, CP issuers had fewer immediate borrowing needs amidst

reduced economic activity and the CP outstanding declined by $82 billion.9

8 All MMFs are required to invest at least 30% of their assets in securities that are considered weekly liquid. If a MMF’s portfolio does not meet the minimum WLA level, it may not acquire any assets other than weekly liquid. An MMF board may

impose liquidity fees or temporarily suspend redemptions if the fund’s WLA decline below 30% of its total assets.

9 Additional information about the effects of the COVID-19 economic shock on the CP market can be found in the SEC staff

report entitled “U.S. Credit Markets: Interconnectedness and the Effects of the COVID-19 Economic Shock.”

34 | U.S. SECURITIES AND EXCHANGE COMMISSION

What was the impact of the Federal Reserve’s Money Market Fund

Liqudity Facility?

The Federal Reserve established the Money Market Mutual Fund Liquidity Facility (MMLF)

on March 18, 2020, to broaden its program of support for the flow of credit to households

and businesses.10 MMLF makes loans available to banks to finance assets purchased from

prime and tax-exempt MMFs. MMLF started its operations on March 23 and initially

intended to provide loans for purchases of CPs, but was extended to include purchases of

certificates of deposit (CDs) and certain municipal securities. MMLF also enabled banks that

purchased assets from affiliated MMFs to finance these purchases with loans from MMLF.

In addition, since March, financial regulatory agencies have announced multiple emergency

relief provisions for banks, advisers and funds. Following these actions, both market

conditions and broader economic conditions in the U.S. appeared to improve with CP yields

and their volatilities quickly falling in early April (Figure 5.5).

The outstanding amount of MMLF loans has been declining since April. The maximum MMLF

utilization reached $51 billion in the first two weeks of April, or under 5% of the net assets in

eligible MMFs. For context, lending by a similar Asset-Backed Commercial Paper Money Market

Mutual Fund Liquidity Facility (AMLF) utilized in September 2008 reached about $150 billion

in its first 10 days of operation, or around 7.5% of assets in prime MMFs at that time.11 As of

September 30, 2020, the total outstanding amount of MMLF loans was around $7 billion; MMLF

accrued revenues from interest and fees to the Federal Reserve were around $166 million, according

to the report from the Federal Reserve.12 Initially MMLF was scheduled to stop providing new

loans after September 30, 2020, but was extended through March 31, 2021.13

10 See the description of Money Market Mutual Fund Liquidity Facility. In the Coronavirus Aid, Relief, and Economic Security

Act (H.R. 748, CARES Act), signed into law as P.L. 116-136 on March 27, 2020, Congress appropriated up to $500 billion

for the Treasury’s Exchange Stabilization Fund (ESF) to support Federal Reserve programs and temporarily permitted the

use of the ESF to guarantee the money market fund industry. With respect to MMLF, the ESF provided $10 billion as credit

protection to the Federal Reserve.

11 See analysis of AMLF utilization here.

12 See “Periodic Report: Update on Outstanding Lending Facilities Authorized by the Board under Section 13(3) of the Federal

Reserve Act,” October 7, 2020 (available here).

13 See “Federal Reserve Board announces extension through March 31, 2021, for several of its lending facilities that were

generally scheduled to expire on or around December 31”, available at https://www.federalreserve.gov/newsevents/pressreleases/monetary20201130a.htm.

DERA ECONOMIC AND RISK OUTLOOK | 35

Summary: Virtual Roundtable on Interconnectedness

and Risk in U.S. Credit Markets

Abstract

In October 2020, SEC staff published a report on the interconnections among the various U.S.

credit markets that sought to identify the extent to which these interconnections contributed to

or mitigated risk, including systemic risk, during the period of market stress from the COVID-19

global economic shock of March 2020. On October 14, SEC staff held a public roundtable

centered on the newly published report and featured a fireside chat with Chairman Jay Clayton

and two panel discussions. The first panel discussion focused on the effects of COVID-19 on six

credit markets spanning over $40 trillion of outstanding debt, including the short-term funding,

corporate bond, leveraged loan, residential and commercial real estate, and municipal securities

markets. The second panel discussion addressed the interconnectedness of the market from a

regulatory perspective and how the COVID-19 economic shock tested the resilience of the U.S.

and international financial markets and the effects of monetary interventions and fiscal measures in

jurisdictions around the globe. Panel members included leading market participants as well as both

U.S. and international regulators. A recording of the webcast is available here. This document is a

staff summary of the roundtable. The Commission has expressed no view regarding the analysis,

findings, or conclusions of the roundtable or of this summary.

The Agenda

SEC staff hosted the virtual Roundtable on Interconnectedness and Risk in U.S. Credit Markets

on Wednesday, October 14, 2020.

The first panel provided a market perspective. Moderated by Sumit Rajpal (SEC), the panel

members were David Finkelstein (Annaly Capital Management), Dawn Fitzpatrick (Soros

Fund Management), Steven Goulart (MetLife), Barbara Novick (BlackRock), and Thomas

Wipf (Morgan Stanley).

The fireside chat was moderated by Jay Clayton (SEC), and it included Mark Carney (COP 26

Finance Adviser and UN Special Envoy), Gary Cohn (former U.S. National Economic Council),

Glenn Hutchins (North Island), and Lorie Logan (Federal Reserve Bank of New York).

The concluding panel discussed interconnectedness and risk from a regulatory perspective.

The panelists were Tobias Adrian (International Monetary Fund), Natasha Cazenave (Autorité des

Marchés Financiers), Andreas Lehnert (Board of Governors of the Federal Reserve System), and

Brent McIntosh (Department of the Treasury), and the moderator was Dr. S.P. Kothari (SEC).

Closing remarks were made by Dr. Mohamed El-Erian (Queens’ College).

36 | U.S. SECURITIES AND EXCHANGE COMMISSION

The Markets Panel

The markets panel began its discussion by looking at the Federal Reserve Board’s (Fed’s) nine credit

support facilities. A panelist explained that the liquidity facilities served two purposes. First, the

facilities provided liquidity to markets that needed additional liquidity. Second, the facilities signaled

that the Fed would step in with liquidity when needed. The willingness of the Fed to step in, and

to do so in an unprecedented way, might have changed market expectations of Fed involvement

on a prospective basis. “When volatility in markets is artificially suppressed, asset prices might be

temporarily pushed up,” said panelist Steven Goulart. “But that also diminishes natural signals that

come from prices. Without the information that market-based pricing provides, over time, it becomes

more difficult for investors to make the right investment decisions.” Another panelist explained how

issuers took advantage of this period to shore up their balance sheets—March, April, and May had

record issuances of investment-grade debt.

The discussion turned to bid-ask spreads. A panelist noted that bid-ask spreads widened early in the

crisis period as both institutions and individuals made a “dash for cash.” The panelist stated that

there were two providers of liquidity at the time, banks and proprietary trading firms. Banks pulled

away from liquidity provision because using buffers in that way exposed them to potential liquidity

and other implications related to stress testing and capital. Proprietary trading firms stepped back

from market making—they turned off their trading algorithms—because they had concerns about the

quality of data and increased volatility. Panelist Dawn Fitzpatrick said, “Until the Fed showed up, there

really was no material marginal buyer.”

In a discussion about improving the resilience of the short-term funding markets as a whole, panelist

Tom Wipf said, “The Treasury market needs to work, and the repo market needs to work. And the

thing that would serve to enhance that a lot would be to minimize to as close to zero as possible

counterparty credit risk and intra-day credit risk.”

The panel discussed money market funds during the crisis this year. Panelist Barbara Novick noted,

“Everyone values liquidity in a period of uncertainty. Any solution [to the liquidity problem that]

we think about has to take that as a given because, yes, people will run again for cash if there is a

period of uncertainty of this magnitude.” She expressed concern about the hard link between a

money market fund having its liquidity drop below 30% and the triggering of a board meeting for

considering whether to put down gates or impose redemption fees, which she believes may have

spurred uncertainty.

The discussion included corporate bonds with an emphasis on corporate bond mutual funds and

exchange traded funds (ETFs). A panelist discussed different ways of meeting funds’ liquidity needs.

One method is to adjust the fund’s portfolio. For example, funds that hold mortgage backed securities

(MBS) get large cash inflows from those underlying assets, while other funds might need to build

“layers of liquidity” by holding cash, liquid assets, or larger issues. A distinctly different way of

meeting funds’ liquidity needs is through swing pricing, which forces the transacting shareholder to pay

the fund for the demanded liquidity. The last part of the bond fund discussion focused on ETFs. ETFs

were given high marks by the same panelist for providing transparency, liquidity, and efficiency.

DERA ECONOMIC AND RISK OUTLOOK | 37

A panelist stated that defaults in the corporate bond market have been high in 2020, and that the

evidence suggests that defaults might get higher, but that the default rate varies substantially across

industries. In particular, high-yield energy defaults rose to 24% in September while high-yield

ex-energy defaults were less than 4%. However, the panelist noted that credit enhancements were

much more common at the start of the 2020 crisis than they were during the 2008 Great Financial

Crisis (2008 GFC), which might help explain why the 2020 default rate was not worse.

A panelist explained that credit risk transfer securities (CRTs) are not attractive securities for

conservative investors such as insurance companies because CRTs are levered instruments that have

junior positions in MBS that are typically rated BBB or lower. Panelist David Finkelstein expanded

on the riskiness of CRTs when he said, “The combination of structure leverage and balance sheet

leverage, when markets are volatile, can lead to pricing and selling pressure that goes well beyond

the fundamental value.” Nevertheless, he noted that CRTs have a number of positive attributes,

including that they enable government-sponsored enterprises to reduce their credit exposure.

Two panelists highlighted two risks in the mortgage market. First, many banks have left the

origination and servicing markets, leaving thinly-capitalized non-bank entities in their place. This

amplifies the cyclical access to credit. Second, mortgage real estate investment trusts (mREITs) are

public companies with a high degree of transparency so activity is well known. One of the panelists

suggested that leverage in this market needs to be reduced.

The panel ended with a discussion about the future of commercial real estate. A panelist noted

that there are short-term weaknesses in many sectors, including hotels and experiential retail.

Nevertheless, the panelist suggested that commercial real estate is a long-term asset that will

perform well over a long-term horizon because firms are unlikely to have large portions of their

employees telework over the long-term, firms might de-densify their offices to reduce health risks,

and some real estate might be re-purposed.

Fireside Chat

The fireside chat panelists emphasized that “muscle memory” was a key reason the financial

markets recovered so quickly in early 2020. When regulators and central banks needed to step in,

they did not have to reinvent the wheel because they were able to review actions taken in response

to the 2008 GFC. This enabled them to act quickly and decisively. Given the success of relying on

the 2008 GFC playbook, panelists recommended that regulators and central banks take steps to

memorialize the 2020 responses for use during future crises.

A panelist noted that the Treasury market is the world’s most liquid bond market and that it is

used to benchmark a broad set of assets. The panelist highlighted that in normal times, these

interconnections improve trading and pricing efficiency, but in March 2020, several key metrics

increased dramatically due to heightened uncertainty stemming from the COVID-19 pandemic.

The price premium of on-the-run Treasury securities increased dramatically as broad groups of

investors bought on-the-run Treasury securities and sold off-the-run Treasury securities. Panelist

Lorie Logan said, “The Federal Reserve’s purchases of Treasury securities and, I would say, more

38 | U.S. SECURITIES AND EXCHANGE COMMISSION

importantly, its commitment to do more if necessary, I think, really helped stop this rapidly worsening

dynamic that we saw. The impact was...direct through alleviating supply-demand imbalances. It

was also indirect by reducing dealer inventories and better positioning the dealers to play their

intermediary role and providing assurance that liquidity improvements would last for some time.”

A panelist noted that the bond ETF market has grown dramatically since the 2008 GFC, and that

it is highly interconnected with the cash market for bonds. The panelist discussed how bond ETFs

enhance liquidity and help improve the price transparency of the bond market. However, the panelist

also noted that bond ETFs trade at a rapid velocity; they offer effectively daily liquidity; and they

provide instant price transparency. This is problematic because bond ETFs represent ownership claims

on loans that have none of those characteristics. He observed that bond ETFs are doing maturity

transformation without all of the regulations of the banking sector.

Panelists discussed international cooperation during the early months of the pandemic, noting that the

demand for US dollar liquidity extended beyond US borders. A panelist highlighted that although it is

not well known, the Fed’s actions were extensive in the global dollar funding market. Another panelist

emphasized how the Fed’s actions in swap, foreign exchange, and other markets helped the US by

helping foreign investors better manage their dollar investments in the US.

The panel also discussed how today’s global markets are highly interconnected. Panelist Glenn

Hutchins said, “To think of these markets as somehow separate is to have a very antiquated view of

how markets are actually operating and how the infrastructure is functioning today.”

The panel discussed that one of the ongoing risks in the financial markets is infrastructure. A panelist

noted that there have been huge investments in improving trading technologies in recent years that

have not been matched by investment in clearing technologies. Indeed, equities trades happen in

microseconds, but settle in days. The panelist argued that this delay exposes the buyer and seller to

risk. Although margin requirements mitigate the settlement risk, the margin requirements are costly

because they tie up capital, removing it from the markets during the long delay.

The panel also discussed access to credit across market participants. Panelist Gary Cohn said, “We’ve

got those that have access to the capital markets and those that don’t. And there is...nothing in the

middle right now.” Additionally, another panelist noted that some disadvantaged communities are

not connected to the financial system. This panelist argued that rectifying this would create engines of

capital accumulation that benefit the communities and the entire economy.

Panelist Mark Carney noted that during the 2008 GFC and the 2020 pandemic, regulators and

central banks played essential roles by stepping in and allowing market participants to take a breath.

He discussed how no private institution is able to provide the liquidity that is needed during systemic

crisis periods: “The challenge for authorities is we cannot expect and should never expect private

entities to self-insure for systemic risk. That is a ridiculous burden to put on private entities.”

DERA ECONOMIC AND RISK OUTLOOK | 39

The Regulatory Panel

The regulatory panel began with a discussion of three groups of actions taken by the Fed and

the Treasury to stabilize the markets. First, to address strains in funding markets, the Fed and

Treasury established a few emergency lending facilities to backstop commercial paper markets

and money market funds, and they also opened a credit facility for primary dealers. Second, the

Federal Open Market Committee (FOMC) took actions to aid in the functioning of the Treasury

market, including purchases of Treasury and agency securities. Third, the Fed and Treasury

created emergency lending facilities to backstop longer-term credit markets. A panelist highlighted

that some of these tools were old—based on actions taken during the 2008 GFC—and were

implemented quickly, while others were new and required more time to implement. Panelist Tobias

Adrian said, “Money markets were drying up. Treasury markets were drying up. And equity/

derivative markets were also severely strained. And so the very forceful, swift, and timely action [of

the Fed and the Treasury] was extremely effective.”

The panel also discussed how the Fed and Treasury actions affected markets outside the US.

Panelists mentioned that there were many indirect effects because the US is such a large part of

the global economy, but that there were also numerous direct effects. For example, the Fed

expanded its foreign exchange swap markets and its repo facilities. The discussion also highlighted

the cooperation among global regulators and central banks, including the European Central

Bank and the Bank of England that resulted in actions that cushioned the negative economic effects

of the pandemic.

The panel continued the international discussion by focusing on money market funds in European

and other international markets. A panelist explained that money market funds differ across the

globe in terms of fund structure, fund currencies, and fund regulations. Yet, the most stress was

in the US and European markets. “We consider last March as a real-life stress test...there had

been very significant reforms in this segment of the market...with the objective of strengthening

the resilience of money market funds...and still, for a second time in only a decade, there had to

be interventions,” Natasha Cazenava said. Another panelist explained how bright lines tend to

encourage run behavior due to a potential first-mover advantage, and suggested that one regulatory

challenge is to preserve or enhance liquidity without creating a new psychological barrier.

The panel also discussed the concern held by some commentators that interventions by the Fed

and the Treasury might, over the long term, encourage risk taking and increase moral hazard in the

financial system. However, panelist Brent McIntosh explained, “The problems here were driven not

by an inordinate amount of risk in the financial systems but driven by a health crisis that no one

could have anticipated.”

The panel next discussed that some commentators have observed that policy interventions

happened only in the credit and fixed income markets even though equity market volatility and

losses were larger. Panelist Andreas Lehnert contrasted equity and credit markets by saying that

“because equity markets are much more volatile...there is less leverage...the system is designed

to take large losses.” Another panelist suggested that another reason for focusing on the credit

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and fixed income markets is that credit market participants rely on the credit markets to finance

themselves. Businesses, non-profits, state and local governments, and households rely on credit

markets for their day-to-day operations. The panel also noted that the goal of the Treasury was

not to support investors or to support the market per se. Instead, the Treasury interventions were

targeted at keeping the economy running and workers supported.

The panel concluded by building on the fireside chat’s conversation about potential underserved

markets. The panelists made several points. First, the banking sector was well capitalized when

the crisis began, and, unlike the 2008 GFC, the 2020 crisis is not a credit crisis. Second, the Small

Business Administration’s Paycheck Protection Program (PPP) distributed more than $500 billion

to small businesses, which is on par with the annual borrowing of small businesses. Third, there is

some survey evidence that suggests that access to credit is not one of the most pressing problems of

businesses right now.

Closing Remarks

Mohamed El-Erian offered closing remarks for the conference. He began with the hypothesis

that “we have gotten hooked, as a society, on using public and private credit and leverage as a

means to pursue economic growth.” He argued that we, as a society, have gone too far over the last

few decades with finance as a means to generate economic growth. He provided somber alternative

interpretations of the current state of affairs. In reference to the 2008 GFC, for example, he said,

“We won a very important war, the war against a global depression, and that was a meaningful

win. But we didn’t establish the peace, the peace of growth that is high, durable, inclusive, and

sustainable.”

There is an old Wall Street mantra that says “don’t fight the Fed.” Dr. El-Erian argued that that is

changing into “rely on the Fed to cover your back.” This reliance has already resulted in excessive

risk taking that is irresponsible for the entire financial system, according to Dr. El-Erian. He argued

that simply increasing the amount of leverage will not get the growth we need nor will relying on

the Fed’s umbrella to cover an increasingly large fraction of the financial markets ensure long-term

stability. “There is going to have to be a fundamental mindset change,” Dr. El-Erian concluded.

“Otherwise, general financial stability is going to elude us. And if that happens, I think that

certainly my daughters, and the ones after them, will suffer.”

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