The Federal Reserve’s emergency rate cut on Tuesday didn’t go over well, at least as far as the stock market is concerned. Investors might be reading the situation incorrectly.
There’s the argument that rate cuts have been priced in, so traders sold the news. Data from Bloomberg show expectations for a rate cut spiked last week, fully pricing in at least a quarter-point cut by the next scheduled Fed meeting on March 17-18, as virus fears took hold of markets and caused the worst selling since the 2008 financial crisis.
There’s also the argument that Tuesday’s intermeeting 0.5% rate cut suggests the virus and projected impact on the U.S. economy is much worse than feared.
“We’ll argue the situation didn’t play out exactly as Powell might have envisioned,” said Ian Lyngen of BMO Capital Markets, referring to Fed chief Jerome Powell. “It’s doubtful that when [he] left home this morning he thought, ‘50 bp will really crush the stock market,’ ” Lyngen said. But it did, and the S&P 500 (.SPX) fell 2.8% Tuesday, while the Dow Jones Industrial Average (.DJI) dropped 2.9%.
Lyngen says the precipitous slide in equities over the past week was the driver behind the Fed’s rate cut to begin with, as the spike in equity volatility translated to tighter financial conditions. That’s where it becomes problematic. “While stocks initially rallied on the ‘good news’ of rate cuts, the optimism quickly faded as the intermeeting nature of the move raised more questions than it answered,” he said.
If the rate cuts were a self-fulfilled prophecy, how can the Fed’s move be interpreted as a signal that the situation is dire?
Investors need to take a step back, says Michael Arone, chief investment strategist at State Street Global Advisors. If you look at the past times the Fed has done emergency rate cuts, they’ve been in response to crises like the bursting of the tech-stock bubble, the Sept. 11 terrorist attacks, and the 2008 financial crisis.
Part of the selloff Tuesday was because investors think the Fed is putting the coronavirus on par with those crises, Arone said, but it isn’t close to carrying the economic magnitude of those events.
“We will see a rebound,” Arone said, as early as this summer.
If Arone is right, a rebound in economic activity later this year could begin as the Fed’s latest rate cuts start to kick in. Economists say rate changes operate with a lag of somewhere around three to six months, depending on the economic backdrop.
There’s another reason to bet a recovery could start around the summer: Viruses have a hard time surviving warm weather. The Centers for Disease Control and Prevention say viruses including the common cold and flu spread more during cold-weather months, though they say it isn’t yet known whether weather and temperature affect the spread of the novel Covid-19, the respiratory disease caused by the new coronavirus.
Some observers say that the Fed can always take back these latest rate cuts if the virus doesn’t wind up wreaking much havoc on the U.S. economy, or the damage is reversed relatively quickly. Many economists predict a hit over the coming quarters, but one that will be mostly reversed sooner than later as the supply chain snaps back and demand for goods is delayed, not lost.
But the Fed has been pretty asymmetric over the past few decades, in terms of its propensity to cut versus lift rates, said Peter Boockvar. chief investment officer at Bleakley Advisory Group. “They’re so easy to ease but drag their feet on hiking” he said, predicting that the Fed keeps rates where they are—or even lower—even if the virus blows over.
There is, of course, the risk that the situation does materially deteriorate and the Fed has little to work with in supporting the economy, given that interest rates are now in a range of 1% to 1.25%. That’s not Boockvar’s base case. For him, the bigger risk is an inflation shock as supply comes back online and faces pent-up demand, setting the U.S. economy up for a stagflation scenario where growth is sluggish and inflation is hot.
For now, though, markets might be in a better spot than they realize. “Investors need to ask if this seems similar to the last financial crisis, to the tech bust,” Arone of State Street said. “With lower rates and the VIX [the option market’s fear gauge,] above 30, investors should be able to get bargains. Putting some money to work isn’t a bad idea right now.”
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