In these times of uncertainties about the continuation of 10+ years economic expansion and bull market, we continue to see the increasingly intervention of central banks in the economy and their responsiveness to changes and events that may affect this trend.
The black swan of the Coronavirus outbreak affected financial markets worldwide and constitutes a tangible threat for the economy if fear and prevention measures stay in place.
On the 3rd of March 2020, the Federal Reserve promptly reacted to this event buy cutting interest rates by 50 basis points, bringing them between 1%-1.25%.
This aid comes into an environment where the “economic fundamentals are solid” and gives a clue about what we should expect for the future, at least for what concerns the intervention of the central bank in case of a downturn.
Coronavirus Black Swan
From a financial standpoint, the worldwide outbreak of the SARS-CoV-2 during the first months of 2020 represents a well-known type of risk (or at least it should) referred to as black swan.
A black swan event is a rare and unforeseeable event with a huge impact, that can’t be predicted and to some extent can’t be even imagined.
Nobody really knows what the long-term effects of the coronavirus will be, at the same time, nobody can know exactly the effects in the short term.
A position of uncertainty that got priced on financial markets in a very short time during the last week of February 2020.
There S&P 500 recorded the fifth worst weekly performance in the whole history of the index. Only events like the ’29 depression, the global financial crisis of 2008, the French invasion by Hitler and the Black Monday of 1987 had a worse impact.
While this may account for a short-term movement, the longer the emergency situation goes on, the worse the effects on the economy. If businesses close for a long period of time and the whole economy slows down, there could be significant negative impacts of growth.
FED Cutting Interest Rates
Even if after twelve years of rising financial markets and economic growth, a slowdown would be natural and we should expect it, the situation is not desirable of course.
The American central bank, the FED, took the leadership of the response of central banks to the coronavirus challenge, cutting interest rates by 0.5%.
Up until now, following the last of a sequence of three interest rates cuts on 30th of October 2019, many expected this “mid-cycle adjustment” to be completed, consequently few were expecting further cuts in the near future.
That was true until the 28th of February, when the FED released an unexpected note, an extremely rare behavior for a central bank considering the impact of future expectations.
In the statement, the president of the FED Jerome Powell declared:
“The fundamentals of the U.S. economy remain strong. However, the coronavirus poses evolving risks to economic activity. The Federal Reserve is closely monitoring developments and their implications for the economic outlook. We will use our tools and act as appropriate to support the economy.”
A declaration that can easily prompt us to expect unforeseen monetary policy moves.
In fact, four days later, the FED cut interest rates lowering the target range for the federal funds rates by 0.5%. Is has been an incredibly rapid and intense cut.
For reference, here is the chart of federal funds rates over the last few years:
This could be an example that may be followed by other central banks around the globe and, as for things in the U.S., we can’t exclude further action. Quite the opposite is true given the high expectation of markets.
Jerome Powell stated that the central bank, even if doesn’t have all the answers to the Coronavirus issue, can help the economy. That pushed the FED to act without hesitation.
The interest rate cut of the 3rd of March is an emergency move by the FED in order to prevent turmoil on the market and in the real economy during the Coronavirus emergency, providing more favorable financial conditions.
While it’s good to some extent in the very short term, we should frame this additional cut in the bigger picture.
In the last decade, we got used to a constant intervention of central banks in the economy with impacts that went far beyond what they were before the global financial crisis.
As a result, today we find ourselves near the end of the economic cycle with extremely low interest rates and central banks that keep stimulating the economy, fostering the assumption of debt as the main driver of economic growth.
Today, the Fed is supporting the economy so much into an environment where the economy is growing with strong fundamentals (as they say).
You can only imagine what would be the response of the central bank during a REAL crisis.
No one knows what could happen. Indeed, we can only guess. However, analyzing the change in the overall direction of the monetary policy, analyzing recent facts and following the central banks declarations (not only from the FED), we can reasonably expect the world to be flooded by currency, much more than ever before.
I think this is the most likely scenario given other alternatives ranging from a deep depression to large and generalized defaults.
The price of this will be inflation. This is actually the continuation of something much bigger started in 1971, however, this is nothing new given that governments and institutions have been devaluating currencies since their inception.
What we know is that central banks will do whatever they can to keep the economy going and to avoid recession. This involves printing more money and over the long-term it will have strong macroeconomics implications.
Long story short: don’t assume that the situation will stay as it is right now indefinitely.
Be prepared, keep in mind the possibility of those kind of moves, create a portfolio with real diversification and hedges and remember that during tough times investors act irrationally and the market provides incredibly good buying opportunities.
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This article is for informational purposes only, it should not be considered financial advice. You can read the full disclaimer here.