Equity futures fluctuated overnight as market participants continue to grapple with the implications of the spreading Covid-19 virus and the anticipated policy responses.Unabated selling will eventually be met with Federal Reserve rate cuts. Given that we are in uncharted territory, we don’t know when those rate cuts will come. The Fed would prefer to hold off until the March meeting in just over two weeks, but a rate cut could come as early as Monday morning.
With new cases appearing in multiple U.S. states, it appears the community spread of the virus is underway. It is possible that it has already been spreading in Washington state for as long as six weeks. With testing ramping up this week, we should expect more confirmed cases. And, sadly, more fatalities attributed to the virus.
It appears that we are going to have to learn to live with this new virus and take rational measures to slow its spread. Schools will be closed, people will be asked to work from home if possible, travel will be curtailed, etc. We can expect more severe reactions and restrictions early on in the process as we assess the relative costs and benefit of various responses. Given the unknown costs, we should expect institutions to err on the side of overreaction for the time being.
The Fed is poised to cut rates, a stance made clear by last Friday’s statement. The ultimate amount of easing depends obviously on the economic outlook. Clearly the greater the extent of the disruption to normal life, the greater the economic cost and the greater the magnitude of the Fed’s action. Economists in the U.S. are busy slashing forecasts in anticipation that activity will slow substantially in the next six months. Goldman Sachs now anticipates 0% and 1% growth in Q2 and Q3, respectively. They also expect a 50bp Fed rate cut in March and another 50bp later in the year
A full percentage point of rate cuts is not unreasonable estimate, but given the rush to re-evaluate the outlook in light of last week’s market meltdown, they may prove consistent with only an overly pessimistic outlook.We just don’t know what portion, if any, of recent market moves are excessive because we don’t know yet how much the economic impact of the virus resembles that of a natural disaster. That said, there also exists the scenario in which more recessionary type-dynamics develop and push the Fed to take rates back to zero.
The question at this point is the timing and magnitude. The timing could be anytime between now and the March 17-18 FOMC meeting; it seems evident that the Fed could easily be forced by financial markets to act sooner – like this morning – rather than later.
I can see where the Fed will continue to hesitate to cut interest rates; they still may want to wait until there regularly scheduled meeting rather than appearing to panic and rush into a rate cut. In addition, central bankers may at least initially focus on the supply-side impact and be concerned that they don’t want to waste a policy response more suited for a demand-side shock. I don’t believe the Fed could use this argument indefinitely to avoid a rate cut, but in the near-term it might induce the Fed inclined to focus on credit market implications more directly if possible. It may be that the Fed’s first response is directed toward market functioning such as expanded repo operations.
Bottom Line: Lots of moving pieces here. The Fed now seems likely to cut rates at least 25bp by the middle of the month. As of tonight, the odds are tilted toward 50bp and sooner. I don’t know that we have a lot of idea about what the Fed is thinking exactly. Powell and his colleagues have really given us very little to work with. The reasonable assumption is that a rate cut is the first option We should consider the possibility that another credit market-specific tool is involved.