Fears of the coronavirus derailing the economy prompted the US Federal Reserve to cut interest rates by 50 basis points in an emergency measure on Tuesday. The FOMC had been expected to meet on 17-18 March but the drastic move “shows desire to provide shock and awe stimulus”, says Edward Park, deputy chief investment officer at Brooks Macdonald. Worryingly, the S&P 500 failed to respond positively and fell a further 2.8 per cent, closing just above 3000 on the day.
Strong action was predicted by markets, with sharp falls in five-year US swap rates, which dipped below 0.9 per cent earlier in the week. Interest rate swaps are used by investors to hedge risk or speculate on changing interest rates, so the fact they are implying average US inflation of below 1 per cent in the medium term is significant, say risk specialists Chatham Financial.
Rate cuts were anticipated before the coronavirus crisis intensified, but Moritz Sterzinger, director at Chatham Financial, said: “By dropping to such low levels, markets are suggesting that the Fed’s response will not only be forceful, but also permanent.”
The Fed’s sudden move will raise expectations of rate cuts by the Bank of England, with the swap market pricing UK five-year rates at 0.44 per cent – effectively predicting a stronger response than when the Monetary Policy Committee made a 25bps reduction following the 2016 vote to leave the European Union.
Restrictions to prevent the spread of Covid-19 affect trade, travel and supply chains and will impact growth and Mr Sterzinger is not alone in his assessment that a technical recession (two successive quarters of GDP contraction) is likely in the US as well as Europe. Yet, the mid-term rates market is implying longer stagnation and investors in shares are faced with a call on whether that’s likely to be the case.
Bringing coronavirus under control and preventing a deeper and longer recession would mean that investors have in effect been handed a chance to buy into some good companies on the dips. Also, as Chatham Financial point out, US dollar borrowers have also just had an opportunity to lock in their interest rate exposure, although they point out the risk this could amount to “catching a falling knife” if the economy does suffer continued pain.
