The Fed took swift action Sunday evening, cutting its policy rate by a full percentage point to 0%–0.25%, pledging to purchase at least $700 billion in securities, and coordinating with other global central banks to maintain as much liquidity in the system as possible. The Fed is also working with banks to encourage lending.
How big of an action is this? It’s pretty close to the full extent of their policy tools. It shows how urgent they see this and how much they’re working to maintain stability and prevent the crisis from spilling into the financial sector.
What is their goal? The Fed knows they can’t fix the underlying issue of the demand shock associated with virus containment measures but are showing that they’ll do whatever they can to provide financial stability, giving Congress a chance to enact fiscal policies such as additional safety net spending and giving those policies the opportunity to work.
What happens next? The Fed can continue to do Quantitative Easing or take other alternative measures, but we’re wary of how well further monetary actions can address the issues here. In his press conference Sunday night, Fed Chairman Powell said this action will replace the meeting originally scheduled for this week. Importantly, he also said they do not see negative rates as an appropriate policy in the US.
What needs to happen? Fiscal policy has to take over from here. The US Congress and foreign governments need to implement decisive safety net spending and tax relief to support businesses and employees severely impacted by the pandemic. Our research team has talked about how fiscal policy may have to take the baton from monetary policy, and this pandemic has accelerated that from some time in the future to the present time.
What fiscal policies are being considered? The US government is considering a range of actions. The below are in the bill passed by the House on Friday night, which is being taken up by the Senate today:
- Two weeks of paid sick leave and up to three months of family and medical leave (with some key loopholes)
- Suspending interest collections on federal student loans (although bills do not actually go down)
- Delaying tax filing deadlines for some individuals and businesses
- Buying oil to fill the Strategic Petroleum Reserve
- Additional funds for food assistance and Medicaid
- Enhanced unemployment benefits
- Free virus testing
Other proposals, which are not in the current legislation include:
- Suspending the payroll tax (which does not help those who can’t work)
- Writing a check to every American
How is the market reacting? Stock markets around the world have been selling off today, with the S&P 500 falling 12%. The downward direction is not a reaction to the Fed, but rather to worsening global coronavirus case counts as well as what the market views to be insufficient health and fiscal policy responses announced by governments around the world to date.
In addition, the market is digesting Chinese economic data for January and February, which showed a worse than expected slowdown in economic activity due to the coronavirus shutdowns. This has two effects:
- It may prompt a stronger economic response from Chinese policymakers.
- It has given the market a sense of the economic impact of lockdown policies.
Where does the market go from here? This is a highly fluid health and economic situation, with the coronavirus case data, policy responses, and market sentiment changing significantly every day. The best way to frame what could happen is with potential scenarios.
On average, across all the recessions since 1957, earnings for the trailing twelve months have fallen by 15% from peak to trough. Price-to-earnings (P/E) multiples tend to contract in advance of most recessions and to bottom months before earnings do. If we do enter a recession in the coming months, it would be unusual in its swift arrival and could also be unusual in its resolution.
Another challenge in predicting what may happen to the stock market is the fact that 10-year US Treasury rates are at all-time lows. Because stock investors are compensated for incremental risk over Treasuries, these extremely low rates mean P/E multiples may not fall as low as they have in past downturns, which could provide some cushion for investors.
As the table below indicates, the market at around 2400 appears to be pricing in moderate recession risk.
KEY TAKEAWAYS: The Fed and other global central banks see their responses as urgent and are doing everything within their power to maintain stability and liquidity in the financial system through the coronavirus crisis. But monetary policy can only do so much to address the underlying issues. Policies aimed directly at coronavirus prevention/mitigation as well as those that support workers and businesses impacted by the pandemic will be critical moving forward. The market is currently pricing in moderate recession risk and we expect it to remain unusually volatile in the coming weeks and months.
We hope this communication provides some perspective. Please let me know if you have any questions. |
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