The Federal Reserve is in save-the-economy mode.
It just announced it will inject $1.1 trillion of cash into the banking system to keep short-term lending alive in the U.S. economy, which is likely at the beginning of a deep recession and an economic stoppage caused by the coronavirus.
The central bank will also buy $107 billion of treasury securities and mortgage bonds to keep rates, especially those of mortgage bonds, low.
As the Fed has stepped in to add liquidity into the economy, stocks have not reacted well. Since the Fed cut its benchmark lending rate by 0.5 percentage point on March 4, the S&P 500 has fallen 23% That’s. part of a broader bear market that has seen the index fall 29% from its all-time-high to date.
Investors have wanted to see stimulus — both monetary and fiscal — and they’re getting both kinds. They’re getting it to the tune of trillions of dollars in aggregate, a significant portion of total U.S. GDP.
But stocks, most on Wall Street agree, are range-bound at best and in free-fall mode at worst until the coronavirus pandemic ends.
The problem is that no matter how liquid households and businesses are, consumers and employees afraid of getting sick will stay inside. Consumer and business spending has been rocked. The economy is likely in recession and will not emerge from contraction until the virus is contained.
The government is spending money at a staggering pace not to fix the current economic wreckage caused by the virus, but more immediately to keep companies in businesses and households from crumbling, so the eventual recovery will be as painless as possible.
Here’s a look at what economic circuits have become dismantled, what the Fed is doing about it and what the ultimate impact on stocks may be.
Lowering the Fed Funds Rate
The Fed, of course has drastically lowered the federal funds rate, the rate at which member banks borrow from each other to keep financing running through households and companies.
The rate before the outbreak was as high as 1.75%. It’s now as low as 0%. That’s to keep borrowing costs low so companies that are now raising debt to remain liquid while revenue falls can do so with limited burden and can get back to business comfortably later on.
The government is now lending hundreds of billions of dollars to airline companies and Boeing (BA) - Get Report, as those companies face substantial fixed costs while revenues are essentially nonexistent.
Lower rates help with all this.
Businesses across the economy briefly saw access to short-term-debt capital cut off. With minimal revenue in all sectors, exception for consumer staples and utilities, credit quality had plummeted.
As investors have been doing anything they can to raise cash — selling stocks, high-yield bonds and even safe treasuries — they’ve largely pulled money out of money-market mutual funds.
Those funds invest in commercial paper (short-term debt that companies issue) for investors parking cash for short periods. Those funds have to sell commercial-paper assets to return cash to investors.
When the price of the commercial paper falls, bringing the yields higher, the cost of short-term borrowing for companies rises. Companies then face a liquidity problem.
So the Fed has authorized one of its financing vehicles, partly guaranteed by the treasury, to finance institutions that can then lend to money-market funds. Those funds then can resume buying commercial paper, keeping yields low and companies more liquid.
Without an influx of new investors, whether money-market funds will resume buying assets is "a very good question,”Stan Sokolowski, senior portfolio manager at CIFC Asset Management, told TheStreet.
If funds see more redemption requests from investors, Sokolowski said, they’ll sit on their cash or raise more. If they think the redemptions will abate, they’ll buy more assets.
Mortgages and Credit Spreads
Part of the Fed’s total program to purchase bonds is to lower the cost of capital for people and businesses for the immediate term and for when activity resumes.
Credit spreads have widened significantly. Historically, investors demand roughly 5% more interest on riskier, longer-term corporate bonds than they do on safe 10-year treasuries, according to research from Canaccord Genuity’s chief market strategist, Tony Dwyer.
As credit quality worsens and investors sell those bonds, the spread is currently at 10%.
As the Fed lowers rates through its many mechanisms, the spread may compress, relieving the economy of a high cost of capital.
The mortgage-bond-buying program also keeps mortgage rates low – although that hasn't yet happened. Mortgage spreads usually sit at around 1% but are now at 1.5%. If the Fed manages to that cost low, household-debt burdens relax and home-buying maybe even strengthens when the virus ends.
Impact on Stocks
The market doesn’t care. Yet.
But when businesses and households get back up and running — and there will be casualties — the recovery may be sharp if there is enough cash and low enough interest rates.
“Once we get that, I do believe that the market will rebound and risk assets will take off,” Marc Pfeffer, chief investment officer of CLS Investments, told TheStreet.
Still, many strategists and economists have noted that not all job losses will be recouped and that retail-store and manufacturing plant openings may be slow.
Bottom Line: Stocks may rebound, but the degree to which they do and the timing are anything but certain.
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