Yield Curve Just Predicts Fed Action
Many of us thought the Fed wouldn’t cut rates until its March 18th meeting. But instead it did an emergency 50 basis point cut on Tuesday. This decision didn’t calm markets. Before we get to what Powell stated and the impact it had on markets, let’s look at what did predict the Fed’s action: the yield curve. The yield curve is known to predict recessions. But instead of inverting before recessions, it has inverted before Fed cuts.
As you can see from the chart below, the 10 year yield being below the Fed funds rate predated rate cuts. Before the Fed cut rates on Tuesday, the entire curve was below the Fed funds rate. That was an obvious signal rates were too high. The market dragged the Fed kicking and screaming. Fed had previously stated it would wait to see how its 2019 cuts impacted the economy before changing rates. At its last meeting, it said policy was in a good place. The market’s react to the coronavirus caused the Fed to change policy.
Emergency Cuts Are Rare: First In 11.5 Years
This 50 basis point emergency cut is a massive deal. The chart below shows the previous emergency cuts in the past 20 years. There were only 6 emergency cuts in the 21st century before this action. Two in 2001 were related to the 2001 recession and 3 were related to the 2007-2009 financial crisis. The only cut not related to a recession was after 9/11.
Fed is now in a position of weakness because it will be very close to the zero bound once it cuts on March 18th. Yes, you read that correctly. Fed is expected to cut rates another 50 basis points in 2 weeks. Just a few weeks ago, the Fed was expected to cut rates 2-3 times all year.
Now, it will be cutting rates 4 times in 1 month. After that, the Fed will have just 2 cuts left before it hits the zero bound. It’s likely that we see some parts of the curve go negative in the next recession. However, I’m not predicting a recession this year yet.
What Powell Stated
Powell’s statement on Tuesday was important because the Fed’s blackout window starts on Friday. He needed to get this right. Based on the market’s reaction, he didn’t. Powell stated, the Fed “saw a risk to the economy and chose to act.”
He went on to say, “The magnitude and persistence of the overall effect on the U.S. economy remain highly uncertain and the situation remains a fluid one. Against this background, the committee judged that the risks to the U.S. outlook have changed materially. In response, we have eased the stance of monetary policy to provide some more support to the economy.” Finally, he added, “For us, what really matters of course is not the epidemiology but the risks to the economy.”
Impact On The Market Was Very Temporary
Powell didn’t give any analysis on the potential risk of the coronavirus. Critics of the Fed claim it is trying to stop a virus with rate cuts, but it’s clear Powell was just trying to ease financial conditions. It doesn’t look like he succeeded in that. As you can see from the chart below, financial conditions tightened.
There was a brief rally in stocks after the hike, but that quickly reversed course. The idea that this Fed rate cut would be enough to calm markets was wrong. That doesn’t mean the Fed was wrong to cut rates. The Fed was forced to cut rates. If the Fed didn’t act, the situation could have gotten worse, but the Fed’s action didn’t make it better.
Now, I wouldn’t go as far as saying this Fed rate cut inspired fear in markets. There was a report that the virus is more deadly than expected which may have caused markets to panic further. If the rate cut was already priced in, how could it inspire fear?
Logic that a cut inspires fear implies that a hike would inspire confidence which is obviously ridiculous. Lower rates are going to help borrowers and people refinancing their mortgages. If coronavirus cases stop growing outside of China, markets will stop panicking.
Past Reaction To Emergency Rate Cuts
History lessons are important when rare events such as an emergency rate cut occur. As you can see from the chart below, the S&P 500 rose on the day of 3 of the prior 7 emergency cuts occurred. Stocks declined during 2 of the 3 emergency cuts during the financial crisis. Fed couldn’t stop the panic just by cutting rates. More action needed to be taken and markets needed to flush lower.
In the current situation, we could see coordinated fiscal and monetary action in which small and medium sized businesses are given extra lines of credit to avoid going out of business. These could be necessary lifelines. Clearly, the situation hasn’t gotten to the point where a large portion of small and medium sized firms need this. But the market fears the worst.
It would be great if the government worked on the issue before it became a disaster. Small hits to earnings don’t hurt the intrinsic value of a firm with a business that can handle weakness. However, small firms don’t have a strong capital base and a large credit line to lean on. That’s why the government stepping in can help.
Is The Fed Out Of Ammo?
Because markets are moving so fast, little attention is being given to whether the Fed will be able to fight a future recession which could occur within the next few years assuming one doesn’t occur in 2020. The situation is very simple.
Either the Fed will hike rates again after this coronavirus issue is over, or it will have little leverage on rates when dealing with a future recession. It will need to come up with new tools and do another round of QE which might not be effective.
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