Fed Update

by | Mar 4, 2020 | Blog, Fixed Income

Originally posted at The Backcourt Report

Fed Cuts Rates 50 bps

The FOMC voted unanimously to cut its overnight target range 50 basis points to 1.00% – 1.25% in an intra-meeting decision. This was an emergency policy action geared in reaction to the Coronavirus fears and new elevated risks to economic activity. The Fed stated the fundamentals of the U.S. economy remain strong, although global risks are heightened and potential disruptions to the global supply chain could spew over into the U.S. economy.  We are already seeing disruptions in Asia and Europe.

Essentially the emergency rate cuts were implemented to avoid further negative impacts on the U.S. economy if the coronavirus is as bad or worse than expected. Typically rate cuts are used in the face of lack of market liquidity or to combat high borrowing costs that discourage business investment, but interest rates are already historically low.

Powell’s comments during his press conference:

“The virus outbreak is something that will require a multi-faceted response,” including actions from healthcare officials, fiscal authorities, and state and local leaders. He also pointed out the problem that some analysts had used to criticize the idea of a Fed cut, saying “We do recognize that a rate cut will not reduce the rate of infection, it won’t fix a broken supply chain.” However, he went on, “we do believe that our action will provide a meaningful boost to the economy” through avoiding “tightening of financial conditions which can weigh on activity and will help boost household and business confidence.”

Aptus Take

We are unsure how lower interest rates will help resolve the issue of a temporary decrease in productivity as citizens fear being infected by the coronavirus and stay home, etc. Rate cuts don’t cure a virus. Thinking back to last year, the Fed cut rates three times, which were prominently driven by global fears of no China trade deal (which Phase One happened and Phase Two is on deck), UK uncertainty with Brexit and the spillover effects to the global economy (which appears to be going smoothly) and a general slowing in the U.S economy.

Following last year’s cuts and the signing of a Phase One China Trade deal, the U.S. economy recovered, and sentiment improved. In our opinion, other than giving some steepness back to the yield curve and to combat the big IF of whether the coronavirus will be worse than expected, this is the only way a 50bps rate cut makes sense to us.

Nearly immediately after the Fed cut announcement, President Trump asked for more cuts. He argued the U.S. is disadvantaged by having the highest borrowing costs and arguably best credit quality, globally. We’d speculate he also wants the same “wind at the back” cheap borrowing costs that Obama had during his 8-year presidency where the Federal Funds rate sat a 0.00%-0.25% from the start of the Obama administration until December 2015.

So where does this leave us?

The 10-year Treasury is at historic lows and dropped as low as 0.93% yesterday… 93 basis points above negative rates. With rates this low, the consensus for forward growth and inflation are LOW . The curve isn’t inverted which visually is a positive and now the spread between 10s and 2s is 34 bps. The market is pricing in more rate cuts at the next two official Fed meetings in March and April.

As investors scramble for yield, we continue to see increased risk in credit products as investors appear to ignore valuations and the increased risks associated with less credit-worthy borrowers. As durations continue to drift longer at lower rates, we don’t see the reward for risk making sense in extending duration to chase yield… if this reprices, it could be an ugly day!  Simply put we are in uncharted waters.

Source: Alpine Macro

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