Presented by Tim Weller
When the Federal Reserve (Fed) unexpectedly cuts interest rates by half a percentage point, as was recently the case, the markets are bound to react. Indeed, after the latest cut (March 3, 2020), the markets dropped, only to rally soon thereafter. So, what does it all mean, and how should investors interpret an unexpected cut from the Fed?
What We Know
To understand both the Fed’s move and the markets’ reaction to it, it’s helpful to reduce the headlines down to the facts. When we do this, we get the following:
- The Fed cuts interest rates when it is concerned about the economy and when it feels that additional stimulus is needed to avoid a recession. Generally, with normal risks, it cuts rates by 25 basis points (bps) at a regularly scheduled meeting, after extensive signaling that a cut will be happening to avoid surprising markets.
- When the Fed cuts rates between meetings, it is rare. When it cuts rates by more than the usual 25 bps, it is also rare. And when the Fed makes this move with no advance signaling, it is extremely rare. All of these things have historically happened only when sudden, extreme risks have threatened the economy.
- Given these points, for the Fed to announce a 50 bp cut, between meetings, with no advance notice, you might conclude that the Fed thinks there is a sudden, extreme threat to the U.S. economy. (In the current context, that threat is the coronavirus.)
Considering these facts, when the Fed (presumed to have the best information available) makes an unexpected cut, it is generally signaling that not only are things worse than expected but that the economy faces a sudden and extreme risk. It makes sense, then, that markets will sell off as a result. In this situation, there must be something coming that no one but the Fed sees, right?
Reading the Fed’s Signal
Except that is not always the case. Returning to the coronavirus threat, new infections have not exploded. There is no new data that the economy is worse than expected. Instead, the data suggests that, prior to the virus, things were improving significantly. The situation has not deteriorated sharply, so the signal from the Fed’s recent action is not one of sudden doom.
Instead, it seems the Fed’s intention with its latest rate cut was to signal that the central bank will support the economy and markets by taking sudden and substantial action even before the real risks show up. The Fed demonstrated, once again, that it will act before anything bad happens, on the mere appearance of risk. So, if the Fed will (and did) act before any real risks show up, markets are free to rally on the lower rates. Further, with lower interest rates, stocks will be worth more. And if things really do take a negative turn? The Fed has already signaled that it will act again.
The Fed Has Our Backs
When the Fed acts to protect the stock market against fear, the Fed put is firmly in place. Of course, economists may argue about its decision to cut rates. But investors should remember that the Fed has our backs, even before anything bad happens in the real economy.
Tim Weller is a financial professional with Weller Group LLC at 6206 Slocum Road, Ontario, NY 14519. He offers securities as a Registered Representative of Commonwealth Financial Network®, Member FINRA/SIPC. He can be reached at 315-524-8000 or at email@example.com.
Authored by Brad McMillan, CFA®, CAIA, MAI, managing principal, chief investment officer, at Commonwealth Financial Network®.
© 2020 Commonwealth Financial Network®