In line with our expectations that the Federal Reserve would move more aggressively and ahead of market expectations, the Fed announced this morning that it will cut the Fed Funds rate by 1.0% to a new range of 0.0% - 0.25%, and also purchase US$700 billion of bond holdings, comprising US$500 billion of Treasury securities and US$200 of agency mortgage-backed securities.
After underwhelming policy responses from the US government so far in the current limited window for effective action, the odds of a short-lived technical recession have risen considerably.
The historic turmoil in equity markets last week, together with worrying signs of dysfunction in fixed income and credit markets despite the Fed expanding repo operations to US$1.5 trillion last week, has forced the Fed’s hand in deploying a bazooka approach.
As has been widely pointed out, monetary policy is a blunt tool against the virus outbreak which is a medical crisis, but it will help in alleviating financial conditions for businesses facing cash flow shocks, and also reduce the risk of negative feedback loops triggered by a potential freezing in liquidity conditions.
Although the Fed has hit the zero-bound and likely has no intention of bringing rates to negative levels, the Fed has not completely run out of tools for more policy easing, and indeed we believe more easing would come if the shock from the outbreak deepens.
What other tools can the Fed deploy ahead?
For one, the Fed can expand the scope, duration and intensity of its quantitative easing program (QE) as a tool for more monetary easing. In addition, the Fed can also make use of forward guidance at the zero-bound as an important part of its policy arsenal, similar to the situation now for the European Central Bank and Bank of Japan.
In its statement, the Fed has committed to keeping rates at zero until it “is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”
The absence of what could have been a stronger commitment to zero rates points to the Fed retaining some flexibility if the virus unexpectedly abates, but again – this also suggests that incremental forward guidance at the zero-bound could be deployed as a monetary tool ahead if needed.
Monetary policy not panacea for market turmoil
Even if today’s Fed action is to add to the relief bounce that begun last Friday, we caution that investors are nowhere near out of the woods yet.
Although the GFC in 2008/9 is in many ways not a perfect parallel to the GCC (Global Covid-19 Crisis), one useful lesson to take from 2008/9 is that rate cuts are not a panacea for market turmoil.
During the GFC, the Fed cut rates to zero in Dec 2008 which set off a relief rally into early Jan 2009, but the S&P500 only bottomed out three months later in Mar 2009 after declining another 20%.
Scale and impact of outbreak remains uncertain as number of cases escalate rapidly
We don’t see the conditions for sustained market stability as yet. First, infection rates are still rising rapidly in major economies – including the US and Europe - and it is difficult to determine the scale and impact of the outbreak until we see signs of stabilization.
Second, even though prices of risk assets such as equities are relatively more attractive after the sell-off, the correction started from valuations at fairly rich levels, and deep value has not sufficiently emerged for bargain hunters to show up in force.
Finally, the speed and magnitude of recent market moves have been sharper than what we’ve seen over the last two decades. This suggests that increased role of systematic strategies, such as risk parity or Commodity Trading Advisors (CTAs), has contributed to exacerbating market volatility and this is set to continue in our view.
In some ways, the GCC (Global Covid Crisis) does not appear destined to match the GFC (Great Financial Crisis) in scale and duration
While a technical recession - which is commonly defined as negative growth for two consecutive quarters – is mostly priced into risk assets today, the larger question for the Fed and investors going forward is whether we would see a longer fundamental correction.
The virus outbreak would cause extreme economic pain while it is ongoing but the nature of the virus shock is expected to be seasonal rather than permanent.
Unlike during the GFC, where the systemic mispricing of real estate-backed financial instruments and derivatives triggered massive asset write-downs and seismic balance sheet shocks - which lengthened the recession as major balance sheet repair required an extended period of time - the virus outbreak today would likely comprise something closer to an income and cash-flow shock as consumer demand is badly hit.
Take advantage of conditions to increase portfolio resilience; Deleverage, diversify, hedge, and switch from poorer quality assets into long-term holdings
If a relief rally takes place, we advise that investors take advantage of this to increase portfolio resilience by deleveraging, diversifying and incorporating suitable hedges into their portfolios, which can include positions in safe haven assets at appropriate entry levels.
A volatile environment will also provide opportunities for investors to switch from poorer quality assets into companies with solid long-term fundamentals that should emerge relatively unscathed from the virus outbreak, and also into selective quality dividend-yielding stocks which should benefit from the search for carry as rates fall.Disclaimer applicable to recommendation
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