North America March 16, 2020 / 09:02 am UTC

Fed Cut, QE and More, But…

By Mike Gallagher

Bottom line: The Fed has cut by 100bps, launched a $700 billion QE program, eased capital buffers and launched new USD swap lines. The Fed’s Powell notes that this is designed to protect the financial system and also to help domestic demand. While the financial system can be supported for now, social distancing suggests that the Fed easing will feed in only with a lag. Extra social distancing measures will also severely hit the U.S. economy in Q2.

The Fed’s action should allow U.S. 10yr yields to ratchet down to 0.5% in the middle of the COVID-19 pandemic, but does not put a floor under the S&P500, which is still likely to test 2350 in the coming weeks and could dive to just below 2000 eventually. 

Figure 1: U.S. Treasury 10-2yr curve 

Source: Macrobond 

Fed To Zero 

The Fed decision to cut the Funds target by 100bps to 0-0.25% came a few days earlier than expected, as the Fed appeared to feel it has no time to waste (we will not have the March 18 FOMC now). The Fed has two objectives in protecting the financial system and also supporting domestic demand. Additionally, measures to support the financial system include $700 billion of Treasury and MBS purchases, which the NY Fed statement is guiding will be front loaded to ensure stability and functioning in the U.S. Treasury and MBS market. Second, guidance to banks to use excess capital buffers to sustain lending, with reserve requirements also cut to zero. Third, new USD swap facilities of 84-day maturities with a variety of DM central banks, including the ECB and BoE, which is designed to stop the offshore USD funding market from seizing up. 

As we noted previously, the main U.S. banking system is in a healthier state than in 2008, which allows liquidity and capital flexibility to support the banking system and in turn back U.S. businesses and consumers. However, the Fed’s measures provide only indirect support to the corporate bond market, where primary issuance has seized up and a cascade of fallen angels in the coming months will ensure havoc in the high-yield bond market and leverage loan markets. This will impact a section of U.S. businesses and then on a second round basis lead to jobs cuts and investment cancelations. This is being amplified by the oil price shock on U.S. shale, though we see this as a transitory shock as OPEC+ is likely to announce new production cuts by the summer. 

The second strand of Fed policy is to support demand. Once the COVID-19 pandemic has peaked, then the effectiveness of lower short-term rates and bringing down the whole U.S. Treasury curve will feed through. The recent Fed Funds cut and lower Treasury yields have been stimulating mortgage refinancing activity. The problem for the Fed and U.S. administration is that social distancing is growing through city and state level activity (e.g. NY pub and restaurant closures) and consumers are undertaking these measures on a voluntary basis. This spreads the pain from the airline and hotel sector to main street U.S. It is also likely to lead to a surge in layoffs and a turn in the U.S. labor market. 

U.S. fiscal measures are coming this week too, but this first around looks to be modest rather than large and they are not going to be enough to counter the adverse economic forecast that threatens to push the U.S. economy into a terrible Q2. While the surge in U.S. testing will allow better containment on COVID-19, the existing number of identified cases risks a further surge in coronavirus that could see more major action (e.g. select quarantine areas) that adversely impacts the American economy. 

The outlook for global trade and globalization has also turned a lot darker, with Europe now the epicenter of the COVID-19 crisis. Italy’s quarantine is being followed by aggressive measures in Spain and will likely see partial quarantines in other European countries. Additionally, Germany has followed other EU27 countries in temporarily closing borders with France and other countries, which will severely impact intra-EU trade and only worsen the recession in the Eurozone. These could be multi-month, while travel restriction on European and U.S. citizens in less impacted countries could last into 2021. This will spillover to global trade, notwithstanding the containment in Asia. 

Market divergence

The Fed policy move to QE4 will produce speculation that the Fed could increase the size of QE in the coming months, given the risks to the U.S. economy. This will likely see U.S. 10yr yields coming down to the 0.50% area in the coming weeks, especially as the safe haven flows out of U.S. equities and credit will remain large. 

The Fed action is not directly designed to support the equity market and a bottom will be reached only when the U.S. COVID-19 rate of change of cases is seen to be brought under control. This could still be a number of months away and in the meantime the U.S. equity market will likely get to cheap levels. As we previously noted 2350 will likely be seen on the S&P500 in the coming weeks based on 2021 Earnings per share (EPS) rebound and March 2009 forward 12mth price/earnings ratio. However, the pessimism on the U.S. and global economy could mean that the focus is on falling 2020 EPS and this could see a drop to 2000 before value starts to curtail the bears. It is also a concern that equity buyback programs for U.S. companies are starting to be curtailed. 

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Analyst Certification
I, Mike Gallagher, the lead analyst certify that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further certify that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.