Too Clever by Half

By Alex Eule |  Tuesday, March 3

Surprise! In recent weeks, the chance of a rate cut from the Federal Reserve was becoming more and more likely. By yesterday, the market had priced in a 100% chance of a 0.5 percentage point cut at the Fed's next meeting in mid-March.

But few expected a cut to come sooner. Well, it did. On Tuesday morning, the Fed stunned investors by cutting the federal-funds rate to a range of 1.00% to 1.25% -- it was the 0.5% percentage point cut that everyone was eventually expecting. But the surprise component ended up taking precedence. It was the first time since the 2008 financial crisis that the Fed made a cut outside its traditional meetings. 

The move jolted investors already on edge about coronavirus and the economy. After briefly rising on the news, stocks turned negative. They fell further after Fed Chairman Jerome Powell spoke to reporters shortly after the cut:

We do recognize that a rate cut will not reduce the rate of infection. It won’t fix a broken supply chain. We get that. We don’t think we have all the answers, but we do believe that our action will provide a meaningful boost to the economy.

Rate cuts are usually greeted warmly by stock markets. Cheaper money means more borrowing, more spending, and, theoretically, more profits. But this time, investors took the cut to mean something different: If the Fed can't wait two weeks to cut, things must be even worse than we realized. The Dow Jones Industrial Average closed the day down 786 points, or 2.9%, erasing a big chunk of yesterday's gains. The S&P 500 fell 2.8%, and the Nasdaq Composite dropped 3.0%. 

Roger Aliaga-Diaz, Vanguard's chief economist for the Americas, was troubled by the Fed's action: 

The nature of today’s announcement could send the wrong signal to market participants, including individual investors who are concerned with recent market volatility. This also creates uncertainty around the Fed’s framework for monetary policy decisions following market dislocations.

This is a rare measure last leveraged during the Global Financial Crisis in 2008. Based on the economic and virus-related data available today, we feel this is a high-risk bet. The Fed may find themselves in a difficult position should conditions deteriorate further, finding themselves required to act forcefully in the weeks ahead.

The bottom line is we won't know whether the Fed made the right decision for weeks or months, long after the coronavirus threat has passed. That's not comforting for anyone, investors and non-investors alike.  

Barron's Randall Forsyth notes that investors are still pricing in another 0.5 percentage point cut by the end of the year.