Sunday afternoon, the Federal Reserve cut interest rates by 1% to almost zero in a surprise move, and as Chair Powell started to speak, the equity futures markets went limit down quickly, followed by an even more precipitous fall at the open Monday morning. What happened?
Here are a few reasons I believe why the market reacted so negatively.
First, by meeting out of cycle and cancelling the routine Wednesday Federal Open Market Committee meeting, an element of surprise was added which is never good when the markets are on edge. Shock therapy is not a great cure for a patient already reeling from shock. The Fed normally prepares the market by floating trial balloons through various Governors speaking and even leaking it to the press to gauge the market’s reaction. None of this was done. For a Fed that has hitched itself to “data-dependence”, the surprise cut communicated that the data was worse than what everyone thinks it is. While the intent was good, the market interpreted this as the Central Bank capitulating too late. The time to cut rates aggressively was a few months ago, when the initial symptoms of broken plumbing showed up in the repo market.
Second, by using all their firepower now markets think there are no more monetary bullets left. Yes, there is still the possibility of negative interest rates, and possible purchases of corporate assets, but Chairman Jerome Powell explicitly denied that either one was on the table at the moment during his telephone conference on Sunday afternoon. The Fed has painted itself into a corner with its credibility now at stake if it goes negative. I expect stealth negative rates via massive amounts of liquidity, which he refused to call QE (again). For a market in pain, using hedge language (i.e. not calling QE what it is, is not soothing).
Third, buying a very large number of Treasuries and mortgages misses the point. This is not 2008 – the mortgage market is not really in distress. What is in distress is the ability of corporations to service their highly levered balance sheets if demand craters, driving down revenues, and spreads widen enough to choke off credit. Buying Treasuries will only exacerbate the problem with spreads. So, extending loans to businesses directly, i.e. “helicopter money”, has to be on the table now, which requires coordination with fiscal authorities. The Chair’s remarks that the Fed expects banks to lend money to corporations just does not square with reality and banks revealed preference for what they do with government money. Banks have shown time and time again that unless there is law to do so, they would (and probably should) hoard the liquidity for the future.
Fourth, by buying Treasuries the Fed is effectively elbowing out all the pensions who need that duration to hedge liabilities. Now these entities will have to compete with the government to lock up debt that is at historic lows. The convexity of long Treasuries creates a vicious cycle where more demand creates even more demand. Buying Treasuries in the name of liquidity provision misses the big picture of risk management-driven demand meeting scarce Treasury availability.
Fifth, by driving interest rates down to zero, suddenly all non-US bonds have a lot less carry for foreigners who hedge their bond purchases. This is a set up for a mass exodus out of negatively yielding European bonds (the only reason to buy them recently was the carry from the currency hedge). Since many passive global bond ETFs own a large proportion of these foreign bonds, a mass liquidation of global bond portfolios will counter most of the purchase of Treasuries from the Fed.
Sixth, regulators still appear to be oblivious to the fact that this crisis is likely different in origin. A lot of the liquidation is likely coming from the short-volatility ecosystem having to hedge all at the same time, and the electronic marketplace of today is not willing to provide the liquidity for this hedging. The Fed is fighting the war of 2008, while to me this event seems closer to the 1987 crisis which was driven by programmatic dynamic replication of options. Until the short volatility ecosystem, i.e. the “shadow financial reinsurance” industry comes back on the radar of the regulators, the illiquidity is unlikely to disappear any time soon.
Though I am not a fan of politicians, what we saw on Friday was close to a master stroke from the administration’s fiscal package. For example, the idea to buy oil with dollars (that the US can print), to fill the strategic reserve had the potential to kill three birds with one stone: (1) put a floor on energy prices, (2) tighten energy sector spreads, (3) exchange fiat dollars for something real – oil. The market rallied smartly on this. Unfortunately, the surprising action from monetary authorities undid the positives from that strategy.
In this state of affairs where the public is quickly losing faith in the Fed, the lessons are simple – investors are largely on our own and have to self-insure. The Fed Put, at least for the time being, has been exposed to be impotent. So maintain liquidity in cash, sell part or all of the Treasuries to the Fed to generate this liquidity, and get ready to buy stocks at a deep discount when the time is right. Credible fiscal action or an expanded set of monetary tools will likely provide the signals for when that time is here.