Don’t Fight the Fed, as the Fed Fights Coronavirus
The Fed chopped its key rate after equities and bond markets tanked last week. The move risks fueling already frothy risk asset prices amid weakening global growth due to COVID-19, which has badly disrupted global supply chains and increasingly damped some services industries.
The U.S. Federal Reserve cut its benchmark interest rate a half point to a 1% lower bound, consummating widespread market expectations of fresh monetary stimulus given “new challenges and risks” from the spread and impact of coronavirus.
Equities had rebounded sharply Monday while the U.S. 10-year sovereign yield had been driven to record lows in anticipation of the move, which Fed Chairman Jerome Powell had flagged Friday in declaring the monetary authority would “act as appropriate to support the economy.”
Thornburg Portfolio Manager Jeff Klingelhofer points out that in cutting from an already accommodative 1.5% to 1.75% level, monetary policy may not have the hoped-for economic and inflationary kick. As a result, “we are likely to see earlier and bigger actions from the Fed.” Indeed, the market is still pricing in an additional cut or two in the months ahead. Yet the pump-priming is a dicey proposition reflecting investor complacence over the now-growing risk of asset bubbles amid a slowing economic backdrop, Klingelhofer notes.
Powell said the COVID-19 outbreak has affected economic activity in the U.S. and many countries. Several of the world’s biggest economies have been severely hit by supply chain disruptions and a sharp retrenchment in their services industries, especially travel, tourism, and activities involving large gatherings of people. For much of February, China, the world’s second-largest economy and its biggest manufacturer, was running at roughly half its capacity. That had knock-on effects on Japan and South Korea, two of its largest trade partners, and they too have also been among the hardest hit by coronavirus.
After a deep 6.3% quarter-on-quarter annualized contraction in the October-through-December period, Japan, the world’s third-largest economy, is expected to contract again in the first quarter, making for a rule-of-thumb recession. Germany, the fourth-largest source of global output, was at an economic standstill as 2020 began, and so is also now at risk of declining output.
Ironically, coming out of 2019, global economic growth was expected to accelerate this year, led by strong U.S. economic fundamentals. But the virus’ world-wide impact is delaying that recovery from a soft patch in global growth over the previous couple years.
Klingelhofer notes the Fed’s and associated stimulus from other major central banks may also be aimed at inflation that continues to run below target. The European Central Bank may soon push its key deposit rate deeper into negative territory while trying to cushion the pressure that creates on its challenged banking sector, in which interest margins have been badly squeezed.
While COVID-19 infections have been declining in China, they have been increasing elsewhere, further hampering activity. Global trade flows and fixed asset investment in many countries have been ebbing. The degree to which the monetary stimulus spurs demand amid a disruptive shock to supply remains to be seen, but rising asset prices amid declining capex spending, not to mention flagging economic and earnings growth, makes due diligence in individual security selection and good judgment in portfolio allocation more important than ever.