3/16/2020
In short, it’s about messaging and credit markets. While lowering interest rates by a percent to zero at this stage may not make a marginal difference to consumer and corporate borrowers on a day-to-day level, it does allow for a further easing in financial conditions. Such accommodation could theoretically help through lower borrowing costs via short-term commercial paper, in a period where firms have been/will be hurting from a damaged economy for likely several months or more. Additional easing and liquidity added to these markets is intended to help stabilize volatility. Low rates also (indirectly) assist valuations for risk assets, as an important input into discounted cash flow modeling. Risk assets have obviously been pummeled, and could benefit from such assistance.
The Fed’s communications are also critical, but the market response is hard to predict and can be a double-edged sword. During the latter stages of the financial crisis, the Fed (and other central banks) taking rates down to zero for the first time demonstrated a strong commitment to supporting an economic recovery for as long as it took to manifest—and rates stayed at that level for years afterward. However, last night’s response was an immediate -5% decline in equity futures (which have since translated to a very negative Monday morning open). Why? On one hand, the Fed was probably hoping the announcement would provide a similar boost in sentiment, and they were willing to take whatever means necessary to support the economy and markets for as long as needed. However, markets almost immediately took the pronouncement to mean the Fed is more worried that we thought, and the impact could be as large as that of the financial crisis a decade ago. By announcing this over a weekend, in emergency fashion, rather than their previously scheduled (now canceled) policy meeting this coming week, this was seen as a ‘panic’ response that didn’t help already-fragile market confidence.
Of course, there are many differences between this situation and the one a decade ago, but the current one remains quite open-ended in depth and duration. The increase in volatility to +/- 5% stock market days has expanded to nearly +/- 10% days, which is very unusual, and a level most investors are not sensitized to. In taking a step back, this new range mirrors the daily (and hourly) news reports of expanded closures of planned events, concerts, and now bars/restaurants in some states, which hit closer to home for all of us in some way. Fundamentally, removing the emotional reactions (which is very difficult to do in times like this for investors), it is a response to the overall uncertainty in determining the fair price of financial assets—price discovery is a very important function at the core of what constitutes a market. When data inputs are fast-changing or inconsistent, we can expect the output for the time being to be fast-changing as well.
In China’s stock market, which has performed far better than others in recent weeks, price recovery coincided with the number of new COVID-19 cases peaking and beginning to decline, social measures loosened, and conditions returning to a level closer to normal. It’s too early to tell whether such a pattern would take place in the U.S. and elsewhere, but in such a fluid and event-driven situation, it did provide markets more certainty than was had prior to the peak.
Prior to the medical crisis, economic growth of 2% or so, very low unemployment, and tempered inflation were considered quite supportive of a continuation of the decade-plus long expansion. While the 11-year bull market has now technically ended, such underlying economic dynamics provide more buffer in trying times today than periods in the past did (which often featured oppressively high interest rates, expensive oil prices, higher tax rates, geopolitical unrest, and other hurdles).