Cutting to the Bone

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February saw the COVID-19 epidemic progress into a global pandemic that touched every continent except Antarctica. Equities dropped steeply in response, with the S&P 500 down nearly 16% at the extremes. In response, the Federal Reserve stepped in on March 3 with an unscheduled cut of 50 bps to the overnight federal funds rate (known as an “intermeeting cut” because it occurred between scheduled Fed meetings). Markets rallied briefly on this news before moving on quickly to continue their journey downwards. Lower interest rates may help corporate investment, but they will not get consumers back out to the movies or onto cruise ships.

Farewell to “mid-cycle easing”

In the modern era of monetary policy, the Federal Reserve has delivered intermeeting cuts only six times. The table below highlights those events and the Federal Reserve’s action at the regularly-scheduled meeting immediately following said cut. In every case, the cut was in response to a steep drop in equity markets and apparently an attempt to shore up the market’s psychology. In addition, every intermeeting cut was followed by second cut of similar magnitude. 

Source. Federal Reserve

Moreover, of the six prior intermeeting cuts, all except for the Long Term Capital Management crisis of 1998 were subsequently identified to have narrowly preceded or occurred during a recession (as defined by National Bureau of Economic Research).

Source. Federal Reserve, National Bureau of Economic Research

The market is currently pricing in a second 50 bps cut on March 18 and a third cut of 25 bps by June or July. If there had remained any doubt that the Fed is in a full easing cycle (as opposed to a so-called “midcycle adjustment“), that has been obliterated by COVID-19 pushing markets over the edge. The chart below shows the magnitude of rate cuts during prior easing cycles, with the average cumulative decline being just shy of 3.0%. 

Source. Federal Reserve

The current easing cycle began with the federal funds rate at a range of 2.25%-2.50%, which is less than the average cumulative decline in prior easing cycles. That means achieving the average cumulative decline in rates in the current easing cycle would require the eventual implementation of negative interest rates or more quantitative easing. Either development would have serious implications for the markets. With U.S. 10-Year Treasuries trading below 70 basis points intraday, it appears that the markets are expecting this situation to last for an extended period. It may be time for investors to prepare for a period of lower nominal rates as well as lower absolute returns from investments in the medium term.

A brief look at history

The transcripts and minutes of Federal Reserve meetings are available online. While a deep dive into those materials is beyond the scope of this month’s market commentary, a few observations are worth making.

First, as mentioned above, intermeeting cuts were almost always in response to (a) a steep drop in equity and energy markets—typically greater than 10% over a short period of time,  and (b) rising credit spreads. 

Second, there is regular hesitance with respect to the optics of bailing out equity markets. The Fed’s typical rationales include (a) signaling that the Fed is ready and willing to act to “minimize tail risks of a really bad outcome,” (b) a nod to the “wealth effect” of falling stock prices on consumer sentiment, (c) rising credit spreads that evidence a deterioration in financial conditions, (d) the use of econometric models, market-implied breakeven inflation rates, and lower energy prices to justify that the risk of inflationary policy isn’t present, and (e) that rate cuts can always be reversed if conditions improve. Even when the Fed is aware that lower rates won’t address the root cause of the problem at hand, it uses the reasons like the foregoing in coming to decision.

This gives insight into the playbook for any further intermeeting cuts. Look for a major catalyst followed by a double-digit decline in equity markets over a short period of time, rising credit spreads, declining energy markets, and low implied breakeven rates.