In a move in which the timing was more compelling than the decision itself, the Federal Reserve (Fed) announced this morning that it unanimously decided to cut its policy rate by 50 basis points (0.5%) from the 1.5-1.75% range to the 1-1.25% range. The surprise move marked the Fed’s first rate action outside of a regularly scheduled meeting since October 2008.
As concerns over the impact of the coronavirus on global economies and markets have intensified, investors’ expectations of policy stimulus increased dramatically. “The Fed’s perspective on the evolving crisis has changed quickly,” said LPL Financial Senior Market Strategist Ryan Detrick. “Even after the emergency action, the bond market is still pricing in more cuts by July.”
The surprise move was likely calibrated to increase the impact of the decision, one in which we believe would be more aptly compared to the rate cut in 1998 in response to the Russian financial crisis and failure of the hedge fund Long-Term Capital Management, rather than the recessionary cuts of 2001, 2007, and 2008. Keep in mind that before 1994, the Fed did not change policy around a meeting schedule, so effectively all rate changes were unannounced.
Stocks historically sold off ahead of these moves, before getting a short-term bounce on the day of and the month following these announcements (see chart). However, performance over other periods shown has been mixed.
We believe the Fed is acting out of appropriate caution to help the economy through what is likely to be an economic soft patch before a potential rebound in the second half of the year, with more room to ease if needed.
The Fed’s action has helped to steepen the yield curve, or the spread between short and long-term interest rates. As shown in the next chart, the spread between 2-year and 10-year Treasury yields has risen sharply to around 30 basis points (0.3%), reversing this negative economic signal that has historically been a good predictor of recessions, though with widely varying lag times.
In our Outlook 2020: Bringing Markets Into Focus published in December 2019, we provided a year-end 2020 forecast for the 10-year Treasury yield in the range of 2-2.25%. With today’s aggressive Fed policy action, more rate cuts being priced into the bond market, the 10-year having broken the one percent barrier for the first time ever, global yields remaining very depressed, and inflation well contained, the downside risk to our yield forecast has increased significantly. All of our forecasts are currently under review based on the developments over the past week, in particular those tied to the bond market. Stay tuned.
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