The Rate Cut and the Market

I know I am coming a bit late to the party on this, as there has already been a great deal of commentary and reaction to yesterday’s unexpected move by the Fed to cut interest rates by half a percentage point. Markets dropped after the announcement, but we are now seeing a strong rally. Pundits are on all sides of the issue. So, what’s really going on?

The simple facts

As regular readers know, when I interpret this kind of situation, I try to make things as simple as possible—but not simpler. In other words, to understand what is happening, we first need to reduce the headlines to simple facts. If we do that here, we get the following:

1. 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 bps at a regularly scheduled meeting, after extensive signaling that a cut will be happening to avoid surprising markets.
2. Yesterday, the Fed cut rates between meetings (which is rare), by more than the usual 25 bps (also rare), and with no advance signaling (extremely rare). All of these things have historically happened only when sudden, extreme risks have threatened the economy.
3. 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 that the coronavirus represents a sudden, extreme threat to the U.S. economy.

Viewed this way, it helps explain both the Fed’s action—which otherwise seems to make no sense and came as a shock to the markets—and yesterday’s market reaction to that move. With the Fed, presumed to have the best information, signaling that not only are things worse than expected but that the economy faces a sudden and extreme risk, of course markets sold off. Everyone was wondering what the Fed knows that they do not. Clearly, there must be something coming that no one else sees, right?

Does the Fed know something that we don’t?

Except, as of today, that doesn’t seem to be the case. New infections have not suddenly exploded, nor has new data come out that the economy is worse than expected. Instead, today’s data suggests that, prior to the virus, things were improving significantly. The situation has not deteriorated sharply, so the signal from the Fed’s action is not one of sudden doom.

Instead—and this seems to be what the Fed intended—the rate cut is a 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 has 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. And that rally is just what is happening today. With lower interest rates, stocks are worth more, which is what we're seeing as I write this. If things really do take a negative turn? The Fed has signaled it will act again.

Fed put in place

The result of yesterday’s action is that, once again, the Fed put is firmly in place, with the Fed acting to protect the stock market against fear. As economists, we can argue about this move. But as investors, we should remember that the Fed has our backs, even before anything bad happens in the real economy. Overall, this cut is a positive signal in the short term.