Key takeaways:
- Federal Reserve efforts to help the economy are underway, including cutting the federal funds rate to zero
- Extremely low long-term interest rates can be positive for many Americans
- The market has seen panics and crashes before and have historically recovered
- Investors should maintain discipline by staying diversified, maintaining a long time horizon, and not overreacting
Recent Economic Stimulus to Address Volatility
The Federal government is taking swift action with monetary stimulus to combat the negative impact of the coronavirus pandemic on the economy and financial markets. On March 15, 2020, the Federal Reserve took the following steps:
- Cut the federal funds rate to zero
The Federal Reserve moves the federal funds rate up and down in an attempt to slow down or speed up the economy. By setting the rate at zero percent, the Fed is attempting to counteract economic weakness due the coronavirus by pushing the gas pedal to the floor. By lowering rates, it makes it more favorable for banks and companies to borrow.
- Announced a program to buy $700 billion in Treasury and mortgage-backed securities
During the 2008 financial crisis, the Federal Reserve made a similar move and began buying Treasury and mortgage-backed securities. This program was known as quantitative easing, or QE for short. By announcing $700B in new asset purchases (the first QE program in years), the Fed is attempting to help support the financial markets and keep interest rates low. By purchasing these securities, the Fed is putting money into the economy to help liquidity and economic movement.
- Activated dollar “swap lines” with five other central banks
To ensure that banks have enough money to lend to individuals and businesses, the Fed has opened “swap lines” with other foreign central banks, which increases the Fed’s ability to receive dollars when it needs them. This also helps ensure that banks are able to have the funds they need to meet customer requests for withdrawals.
Although investors widely anticipated a Fed rate cut to zero percent, the immediate global market reaction was not initially positive. In chart 1 below below, you can see that the Fed had been decreasing rates already over the last few months.
It had plans to lower them further to combat the impact to the global economy caused in part by the coronavirus, as well as geopolitical activity, but acted sooner than planned, dropping the rate from around 1% to 0 this week, following a 0.50% decrease last week — as the coronavirus began to disrupt activity in the US quickly. This is similar to measures taken in 2008 – 2015 in order to help stabilize markets and the economy.
Chart 1: Federal Funds Rate, Target Range Lower Limit
Source: Clearnomics, Federal Reserve
Maintaining Perspective in Volatile Markets
In these historic times, it’s important for long-term investors to maintain perspective and clarity. Having perspective doesn’t mean that there aren’t serious issues affecting public health or the economy. It does not guarantee that the financial journey will be easy.
Instead, just as having the right perspective on a problem can help to solve it, having perspective in investing is about knowing what we can and cannot control. At the public health level, we cannot control the nature of the coronavirus. At the economic level, we cannot change the fact that growth will likely slow for several months. At the market level, we cannot change the fact that there is significant uncertainty and market volatility.
What we can do is react to each of these appropriately. We can heed the advice of public health experts and practice social distancing and proper hygiene. We can keep a close eye on the economic data as it evolves. And, most importantly, we can maintain discipline in our investment portfolios by staying diversified, maintaining a long time horizon, and not overreacting.
Comparing Coronavirus to Past Crises
Given recent events, it’s natural for some investors to draw parallels to past crises. At the moment, there are two primary reasons that some investors are drawing comparisons to the 2008 financial crisis.
One reason is simply that markets have fallen into bear market territory with large swings, both positive and negative, on any given day. Historically, the average daily move in either direction is about half of a percent for the S&P 500. This year, the average swing is almost 2%. A few days have even seen swings larger than 9%. Not only are these swings greater than investors have experienced in 12 years, they are some of the largest since the Great Depression.
The second and more meaningful reason for investors to draw comparisons to 2008 is the fear of what is referred to as “financial contagion.” This can occur if short-term problems in the financial system spread into many areas. For instance, it’s one thing for an individual to go without a paycheck for a couple weeks because their small business is closed. It’s quite another if this spans months, and the individual faces a cash crunch. Multiply this problem across the economy and scale it up for large companies that rely on bond markets for funding, and it can become a serious problem.
Chart 2: Corporate Bond Yields Over Credit Cycles; Yields by bond rating since 2000
Source: Clearnomics, Merrill Lynch Bond Indices
As you can see in Chart 2, credit spreads have spiked in recent weeks, and bond market volatility has risen significantly as well. Credit spreads are an indicator of financial stress and are one concern for those worried about a repeat of 2008. While credit spreads have jumped recently, they are not yet at levels seen during the financial crisis or during 2015-2016 when oil prices collapsed. Recent government stimulus actions are designed to prevent further stress to the credit markets.
What exactly is a credit spread? A credit spread on a bond is a measure of how risky investors believe that bond to be. When measuring the credit spread across the entire bond market, a widening spread is generally a sign that investors look to to gauge if there is stress in the financial system and economy.
How the Coronavirus Situation is Different
But unlike with the 2008 financial crisis, this time, the federal government and the Federal Reserve are on the lookout for signs of an economic crisis and have begun to act swiftly to counteract it. They’ve implemented economic stimulus and liquidity provisions in recent days alongside public health measures. These go hand-in-hand, since one of the main side effects of slowing the virus is an economic slowdown. Thus, a key difference with 2008 is that the Federal Reserve and federal government have playbooks that were developed during the last crisis and can be implemented quickly.
In 2008, it took a long time for the Fed and the government to get involved and help banks and other areas of the economy. Learning lessons from 2008, the Fed has been proactive with its monetary stimulus this time, and the government will likely follow with its own stimulus in order to try to limit the impact to the economy, markets, and individuals.
You can see in chart 3 how stock market cycles have been impacted by various financial peaks and crises over the last 50 years.
Chart 3: Stock Market Cycles, S&P 500 Index over the past 50 years (Log Scale)
Source: Clearnomics, Standard and Poor’s
Additionally, the fact that long-term interest rates are extremely low can be positive for many Americans. These low rates may eventually filter through to lower mortgage rates, personal loans, credit card payments, and more. This could cut costs for individual’s monthly budgets, and possibly boost asset prices such as in the real estate market.
Unfortunately, the flip side is that those who rely on their portfolios and savings for income will continue to have to find it in areas such as dividend paying stocks and higher-yielding bonds. The rates on high-yield savings accounts could be affected by the Fed’s rate cut as well, depending on competition between banks. Still, these products and vehicles should continue to provide much higher yields than normal checking accounts.
Looking ahead and staying focused
For long-term investors, it continues to be important to maintain perspective and focus on what we can control. The history of the market is filled with manias, panics, and crashes which, viewed in hindsight, could have been handled better by investors. While each episode may have its own unique circumstances, the fact remains that, while it may feel uncomfortable at the time, staying disciplined and not overreacting to backward-looking market moves is the best way to achieve long-term financial goals.
For more resources, keep checking the COVID-19 section of our blog here. We’ll be updating it with new information regularly.
