For the first time since the 2008 financial crisis, the Federal Reserve (Fed) cut rates outside of a regularly scheduled monetary policy meeting. And in another first since the financial crisis, the Fed cut by 50 basis points, rather than its typical 25 basis points.
With the surprise cut, the central bank not only seeks to keep the economy growing, it wants to bolster investor sentiment. Fed Chairman Jerome Powell insisted the rate cut will provide a meaningful boost to the economy by avoiding a tightening of financial conditions. He also noted the action should help boost household and business confidence.
The market’s initial response to the Fed’s rate cut was not the reaction we typically see. Stocks and Treasury yields plunged, suggesting investors remain unsettled.
“When the Fed makes an emergency rate cut, there’s always concern that the Fed knows something the market doesn’t,” said Charles Tan, Co-CIO of Global Fixed Income. “In this situation, I don’t think the Fed knows more than the general public, and I think the cuts are an insurance policy and preventive in nature.”
From a market perspective, the coronavirus outbreak is creating a supply shock for the economy. In regions where the outbreak is most severe, people can’t work, and factories are shut down. This has negative implications for economies, corporate profits and consumer spending.
“The market is saying a rate cut is perhaps helpful in stabilizing sentiment, but it can’t really cure the underlying issue—which is the duration and severity of the virus outbreak,” Tan explained. “So, on the one hand, the market was looking for a rate cut, but on the other hand, investors remain unsure about the rate cut’s impact. There are just too many unknowns.”
As the Fed seeks to calm the markets, the ultimate solution to the virus-related volatility likely will come from the medical community. As such, Tan believes the Fed’s move is more about supporting market sentiment and trying to stay ahead of the likely macro data deterioration in coming months.
Tan’s co-CIO, John Lovito, agrees the rate cut likely won’t aid the economy over the next few months. But it may help down the road. “In the near term, the spread of the virus and its impact on economic growth will remain the main focus,” Lovito said. “However, if the duration is relatively short and the impact relatively mild, this rate cut may prove to be very supportive for risk assets in the second half of the year.”
Before anyone had heard of COVID-19 (the current strain of coronavirus), reports of slowdowns in Europe, the U.K., Japan and China were fueling global growth concerns. Because of this, the Fed may not be simply reacting to coronavirus concerns, suggested Cleo Chang, Head of Investment Solutions. “In addition to the obvious slowdown in global growth, the Fed may be reacting to mounting and excessive debt burdens, which will put further stress on corporate earnings growth. The rate cut may be a way for the Fed to get in front of this situation.”
Before this cut, Treasury yields had fallen to record lows in response to global growth worries and a global flight to quality. After the cut, the 10-year Treasury yield dropped even further, falling below 1% for the first time. The rapid decline revived concerns about negative interest rates.
“Negative rates remain a possibility for the U.S., but we don’t believe they’re on the horizon,” Tan said. “It seems unlikely the Fed will drop its target lending rate below 0%, given (Fed Chair) Powell has publicly stated he believes negative rates are a bad idea.”
Similarly, Tan doesn’t believe the 10-year Treasury yield will slip into negative territory. That scenario only becomes likely if the global economy slips into a deep and protracted recession, which is not in Tan’s near-term outlook. He said the recent drop in the 10-year yield is likely due to investors purchasing Treasuries as a “hedge” for their corporate bond and other risk assets, in addition to the bond market’s downgrade of the global economic outlook.
The level of uncertainty surrounding the virus suggests markets will remain highly volatile in the near term. On a positive note, even after the steep sell-off, the stock and corporate bond markets currently don’t appear priced for a recession.
“It’s important for investors to remain disciplined and avoid reacting to short-term market swings,” Tan said. “The key is to maintain a balanced approach to investing across multiple asset classes and sectors. This strategy can offer participation in market rallies and protection in market downturns.”
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