Rate Cuts Are No Vaccine

On Sunday, the Federal Reserve Bank announced a host of emergency measures intended to improve bond market liquidity and reduce borrowing costs, which come in response to rising signs of dislocation across Treasury, municipal, and corporate bond markets. However, Monday’s sell-off highlights that the unfolding COVID-19 pandemic is the key driver of sentiment today, not central banks. Market stabilization may be dependent on a deceleration in new virus cases, announcement of massive fiscal stimulus, or both.

The Fed measures come amid significant market volatility as fears mount over slowing economic growth and commensurate concerns over rising default risk across a variety of industries. The Fed’s response to the crisis is in sync with that of major European central banks and was followed this morning by the Bank of Japan.

Yesterday, the Fed cut its target for the “Fed Funds” rate by 100 basis points (bps) to 0.0%–0.25%, as well as for the discount window rate (via which banks can borrow from the Fed) to 0.25%. The Fed will boost bond market liquidity by purchasing up to $500 billion in Treasuries and $200 billion in mortgage-backed securities over the coming months. To encourage bank lending, the Fed also cut the amount of required reserves that banks hold against expected liquidity needs and encouraged banks to borrow via its discount window. Finally, it announced the creation of a series of swap lines with other central banks to ensure an adequate flow of dollars across markets.

These steps follow previous Fed actions to try to improve market liquidity, including last week’s announcement of unlimited repo lines to primary dealers and an earlier 50 bp rate reduction in March. Markets had accurately anticipated the 100 bp cut, but other actions (such as the asset purchases) may have gone above and beyond. Recent strains in the funding and credit markets and deteriorating liquidity left the Fed little choice.

Today’s sell-off may reflect the market’s perception that the Fed is out of ammo, but is better viewed in conjunction with news that the number of COVID-19 diagnoses is growing in countries including Italy, Spain, and the United States, as well as increasing recognition that a recession might be required to slow the virus’s spread. A large fiscal easing package that helps ease the burden on the most-impacted workers and industries would help mitigate market concerns. But, so too would a reduction in the number of new cases, which is not yet visible on the horizon.

Wade O’Brien, Managing Director on Cambridge Associates’ Capital Markets Research Team