The stock market isn't focusing on what the Federal Reserve is doing right now, but it probably will when the coronavirus is contained.
The Federal Reserve cut its benchmark short-term lending rate to a range with a bottom of 0% this weekend. Stocks, after having watched the Fed throw trillions of dollars of liquidity into the banking system this year, shrugged. All three major U.S. indexes fell as much as more than 10% Monday, causing more stoppages of trading, an ultimate confirmation of panic selling.
The S&P 500 is still 25% below its all-time high and Wall Street expects more volatility.
That's because added liquidity -- though monetary or fiscal policy -- can't get consumers out of the house or businesses to open if the fear is about getting sick.
The equity risk premium of more than 6% shows investors are pricing in an almost sure recession. That risk premium that investors demand in stocks over safe treasuries is far higher than its historical average of around 3%.
But when the virus is indeed contained, risk assets "could snap back fairly quickly," said Marc Pfeffer, chief investment officer of CLS Investments. "More than anything else right now, everyone is looking for clarity. Once we get that, do believe that the market will rebound and risk assets will take off."
One reason the Fed has cut rates is to provide liquidity to be deployed for a recovery. Currently, credit spreads - or the difference in interest rates between high yield bonds and treasuries - have widened to near 8% as corporate bond prices fall. That's according to one index cited by the St. Louis Federal Reserve. The Fed wants to keep corporate borrowing costs low. One fear is that businesses and consumers will return to activity slowly after the virus.
Still, stocks and high yield bonds may price at higher levels once the recovery does get underway.
But some are afraid that low rates can't stimulate much growth from here. Plus, the Fed doesn't have an unlimited amount of cash to deploy into the bond market going forward.
Here's what Pfeffer says to expect the Fed to do through and after a recession:
"Right now they're going to keep rates pinned at 0% on the fed funds rate. They will continue to do as much bond buying as they need. They could buy more. They're looking for visibility and clarity that the economy is going to rebound once the virus passes. The deficits are going to increase [federal budget deficit]."
One factor investors will consider gong forward is that the Federal deficit must be muted, as fiscal stimulus may be a more effective tool than monetary in the future.
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