Over the last few trading sessions, we’ve experienced the fastest correction in the history of the S&P 500. Investors have wiped out more than $5.3 trillion (the equivalent of 6.2% global GDP) from global stocks, the most ever.

source: Deutsche Bank, ZeroHedge.com

As a cause of that rapid move, people want to blame the coronavirus outbreak, which is complete nonsense. The reality is that it is the result of financial, credit and liquidity excesses due to central banks’ operations who have made the money as cheap as it has never been before. It has led investors to take an enormous risk. Complacency and fear of missing out (FOMO) have been the main drivers of many investors' decisions. In simple words, the mindset of market participants has been shaped in a way that they have thought that central banks will always back them. This is famously called as "Don't fight the Fed". The past week clearly showed that this strategy doesn't work forever.


The blue lines on both charts show the Global Money Supply (or Liquidity Proxy - measures M2 money supply - short-term bank deposits, and 24-hour money market funds - for 12 major economies including the US, China, the Eurozone, and Japan), yellow line depicts the S&P 500 index. On the top chart, you can see a very close correlation between money supply and the main US stock index over the last decade, the bottom one shows the last 12 months, at the end of which it is visible that something broke in terms of this relation. One would say that correlation is not causation but we've been living in an era of the cheapest money ever. Corporations have intensively borrowed money to buy back stocks and different kinds of investment funds have used historically low costs of debt to leverage their positions in a variety of asset classes. To bring the numbers up, highly regarded Economist David Rosenberg found out that the correlation between US GDP growth and the direction of the S&P 500 index during this business cycle has only been 7% (historically between 30%-70%). That means the economy has nothing to do with the stock market.

As you can see, we've had this credit bonanza for at least a decade which has led to the longest bull market in history. And yet, after last week's plunge due to this irrationality, most analysts and investors beg for more interest rate cuts by the Federal Reserve.

Let's see then whether these prayers will be fulfilled by the most powerful central bank in the world in the upcoming weeks.


STOCK MARKET LEADS THE FED

When the S&P 500 has been trading more than 15% lower than its all-time highs, the Fed Chair Jerome Powell has issued a statement for which (I suspect) the market has been waiting the entire week.

source: https://www.federalreserve.gov/newsevents/pressreleases/other20200228a.htm

"Act as appropriate", these words have been a continued mantra of the Fed throughout the entire 2019. Thus, Jay Powell has given a clear sign that they are ready to cut rates very soon. This statement also reminds me of the former Chair, Alan Greenspan reassurance after October 19, 1987 crash, when the S&P 500 dropped 22.6%, the largest one-session drop in history. On the next day, Greenspan issued the following:

“The Federal Reserve, consistent with its responsibilities as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”

This support lasts to this day. Furthermore, via these words and subsequent actions, Alan Greenspan killed price discovery. 

So, if the market still has the Federal Reserve's back, when, therefore, can we expect the next interest rate cut and is it going to be 0.25% or 0.50%?

Currently, the Fed Funds Rate stands at 1.75% level. According to Jim Bianco, "The Market is Expecting The Fed to Cut 50 Basis Points Tomorrow Morning". In other words, 0.50% before the US Stock Market opens on Monday. That would mean only one thing - an emergency cut.

"Our guess is this market is expecting thousands of positive infection cases in the US over the next month, leading to huge disruptions. Think tens of millions idled from work, school kids home for weeks, if not the rest of the school year."

Jim is referring here to the coronavirus outbreak.

To put things into a perspective, the last emergency cut by 0.50% has been conducted by the Fed on Oct 8, 2008, when the global economy has been already in the full-blown crisis and the S&P 500 fell more than 30%. This time situation is different in a way that the economic outlook has substantially deteriorated but the economy it's not in a recession and a potential cut would be seen as pre-emptive action. On the other hand, as we know the next Federal Reserve meeting is scheduled for March 17-18. Thus an interest rate cut two weeks before could be also perceived as a panic move and complete capitulation of the US central bank.

What do think the largest financial institutions in the world? Reading about them, we can learn that they also do not exclude a possibility of an emergency rate cut but they rather see the Fed's rate moves on the next FOMC (Federal Open Market Committee) meeting. Goldman Sachs said it expects a 0.75% reduction between March and June. Bank of America 0.50% cut on March 17-18.

In the end, let's look at what the market is saying in terms of the rate probabilities at the next Fed meeting.

source: https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

As you can see, the market is pricing a 100% probability of rate cut on March 18, not by a 0.25% but 0.50%. It has to be noted that in the past, the Fed has always delivered what the market wanted when a probability of its demands has been higher than 80%. Therefore, we can definitely tell that it is just a matter of when not if or by how much the Federal Reserve will lower the costs of credit.


SUMMARY

I personally think that we will not see an emergency cut this week. The Fed will try to use verbal tools or the so-called jawboning to give the market assurance that interest rates will be lowered at the next meeting. It may change if bond yields and stocks will continue their steep declines, as well as the bonds spreads widen even more. We have to keep in mind that there are still 12 trading days till Powell's and his fellow economists' will make their decision. It is worth to note, that the number of new cases daily in China peaked after four weeks and globally we are only starting the third week.

As I am writing this brief piece I am wondering why I barely mentioned the economy, and I think that the most interested people in the markets, such as investors, analysts, the largest financial institutions as well as the most powerful central bank in the world, know that the aim of potential interest rate cut will be to improve market sentiment instead of help the economy. Having said that, let me ask you a question. At what level of rates will you be willing to go to the crowded mall, cinema, theatre or a party and thereby risking a virus infection? Lowering interest rates may temporarily juice the stock market but it won’t support the economy till the outbreak ends.

Thank you.

Seb

UPDATE:

The Fed has cut rates before the March 17-18 meeting (emergency cut) by 0.50%.
https://www.federalreserve.gov/newsevents/pressreleases/monetary20200303a.htm


This is a great opportunity to write about the history of the Fed emergency cuts:

Coronavirus
Lehman Collapse
Subprime-mortgage collapse continued
Days after the 9/11 attacks
Jan and Apr 2001 after the dotcom bubble burst
Russia’s financial crisis and the Long Term Capital Management collapse

My brief comment:
"Over the last decade, stocks have been highly driven by the Fed. It seems like they don't believe the most powerful central bank anymore(need a couple of days to confirm)

After the 0.50% rate emergency cut and the Chairman's Powell special conference stocks have fallen off the cliff"


source: investing.com

Despite that, the market expects another 0.25% cut on March 18 and some Wall Street banks (Citigroup and Bank of America) see one 0.25% in March and one in April.

I call it the race to the zero bound (zero interest rates policy - ZIRP).


The Fed emergency cut has been likely conducted in order to rescue the corporate credit market, bond yields have rapidly risen (however, not as much like at the end of 2018 or even 2016). I personally think the cut was too early but I may be wrong.


IG - Investment Grade Bonds, Junk - Below Investment Grade, in other words below BBB grade.

Meanwhile, the 10 year US yields have breached 1% to the downside.


Panic? Desperation? Capitulation? We will figure it out soon.

Disclaimer: This content includes only personal opinion and that should not be considered professional financial investment advice.


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