Chek the Channels
Lower Rates, Lower Markets, Higher Expectations
The S&P 500 has fallen 13.8% after hitting an all-time high 10 trading days ago. The markets jumped this past Monday on the hope that central banks will respond by lowering interest rates. They gave most of the gains back on Tuesday when the Federal Reserve did exactly that by cutting the overnight target rate by 50bp. This leaves little room for further stimulatory cuts. Does the government have enough ammunition left to combat a slowdown in the global economy, have the markets become weary of government stimulus after ten years of a boom market?
The Fed May Have the Right Tools
- Who says interest rates can’t go negative? The Fed lowered its benchmark fund rate target by 50 basis points to a target of 1.0-1.25%. Some analysts expect an additional cut at the Fed’s next meeting on March 17-18. The bond market responded with many shorter-term bond yields dipping below 1.0% and threatening to turn negative. The thought that we are approaching a point where investors would have to pay lenders to hold funds seems hard to grasp. However, there are several examples of foreign government bonds trading at negative returns. Germany, Japan, France, Spain and the Netherlands all sell bonds with negative yields. In fact, Bloomberg estimates that negative-yielding bonds make up about a quarter of the investment-grade debt globally.
- It’s not the level of the rate cut that matters, but the percentage. When the Fed cut rates by 50 basis points, many investors yawned because they’ve seen 50 basis point cuts before. However, the cut represents a large percentage reduction in rates. The 29%-33% reduction in rates is the largest since 2008, right after Lehman Brothers went bankrupt. The move is a clear signal that the government will do whatever it takes to combat the effects of the virus.
- The U.S. is taking the lead but is not acting alone. In conjunction with the Fed action, on Tuesday morning G-7 finance ministers issued a release indicating that they are ready to act, including taking fiscal measures to support the global economy. A single nation rate cut shifts investment funds from one country to another. A consolidated rate cut encourages idle funds to become invested. While the G-7 statement stopped short of supporting coordinated rate cuts, the call for a joint coordinated action is meaningful.
Economic Stimulation May be Battling More than a “Stay at Home” Consumer
- The economic expansion is long in the tooth. The market and companies are weary of continued expansion after ten years of economic growth. Management has expanded factories, built up inventory and hired more employees. The idea that they will take advantage of lower rates to expand further seems unlikely given lowering consumer confidence and growing uncertainties surrounding the virus.
- It’s a global economy and China has been beaten down. The days of viewing the U.S. as an independent country that trades with partners is over. In today’s global economy, products have inputs coming from all over the world and products that are sold all over the world. China is an important supplier of parts and products to the U.S. Unfortunately, China has been severely weakened in the most recent trade war. While the U.S. has been able to shift some trade to other countries such as South Korea and Vietnam, it remains dependent on China to maintain a healthy economy.
- Don’t look for fiscal expansion to offset weakness. After cutting taxes in 2018, federal debt has risen from $19.5 trillion to $22.7 trillion. The Congressional Budget Office projected an annual deficit in excess of $1 trillion, and that was before the coronavirus outbreak. A slowdown in the economy will negatively affect receipts and could mean deficits that are much larger. Debt as a percent of GDP will rise.
The economic impact of the coronavirus is unknown. However, the resolve of governments to respond to any impact is hard to question. Sure, it is easy to say that the government should have done more to prepare for such a disrupting event while economic conditions were better (lower the deficit, raise interest rates, etc.), but such commentary is Monday morning quarterbacking.
https://www.cnbc.com/2020/03/03/fed-cuts-rates-by-half-a-percentage-point-to-combat-coronavirus-slowdown.html, Jeff Cox, CNBC, March 3, 2020
https://www.bloomberg.com/graphics/2019-negative-yield-debt/, John Ainger, Bloomberg, July 24, 2019
https://www.washingtonpost.com/business/2020/03/03/economy-coronavirus-rate-cuts/, Heather Long, Washington Post, March 3, 2020
https://www.politico.com/news/2020/01/28/federal-deficit-one-trillion-trump-107901, Caitlin Emma, Politico, January 28, 2020