At 401(k) Engineers, it is very important to us that you are well informed about what’s happening in the markets. Here are a few of the key topics of conversation that we feel deserve the most attention this month. If you have any questions or would like to continue the conversation, let us know, and we appreciate the opportunity.
What just happened?
The pace of the news cycle does not show signs of relenting from its roaring pace. Therefore, to keep you updated on what happened over the weekend, we want to provide a high-level insight into the actions the Federal Reserve announced and their potential impacts. On Sunday, the Fed took additional emergency measures in an attempt to stave off further fears from COVID-19.
The primary actions were:
- Cut target federal funds rate to 0% to 0.25% (previously the target was 1.00% to 1.25%)
- This was the largest single interest rate cut in multiple decades
- Purchase $700B in additional bond purchases ($500B in Treasuries and $200B in mortgage-backed bonds).
In subsequent actions, they reduced the interest that is charged to institutions that receive emergency loans from the Fed to 0.25% (previously 1.75%). For reference, the new rate is lower than it was at the height of the Global Financial Crisis. Further, they are encouraging banks to use their liquidity buffers and capital to make loans available for those impacted by the virus.
What is quantitative easing? How may it help?
Quantitative easing (QE) is simply an asset exchange where a central bank, in this case, the Federal Reserve, enters the market and purchases a defined amount of securities, in this case, Treasury and mortgage-backed bonds. The actions taken by the central bank to make repurchases, in theory, allow institutions, such as banks, to lend more as their balance sheet now holds more cash instead of securities. This also creates a large-scale buyer within capital markets, which helps reduce interest rates on those securities.
Why is this relevant now? Because if you're a large commercial landlord, for example, whose tenants can't pay their rent (restaurants, movie theaters, hotels...etc.), you'd be able to issue debt to get you over the Coronavirus hump. The same potentially goes for municipalities that need emergency cash.
The knock-on impacts can also generally lead to higher a risk appetite in the market, as low-interest rates may make risk assets more attractive.
Will it help?
In our view, this action is welcome to try to help ease some fears, but as we have said before, interest rates will not stop the spread of COVID-19, which is the fuel for this fire. The tangible benefits will be improving access to capital and providing liquidity. As we see states and businesses decide to reduce or suspend operations, these can serve as crucial lifelines to stay afloat and avoid unnecessary or temporary layoffs. Further, once we get to a recovery phase, it could help make the snapback to business as usual (along with recovery in capital markets) faster than it otherwise would have been.
Yet, in our view, we need to see a meaningful reduction in new confirmed cases and massively expanded testing to fully calm fears and help turn the tide in this crisis.
What happens if interest rates go negative?
As yields on U.S. government bonds have collapsed from their pre-COVID levels, a question you may face is what happens if U.S. yields drop below zero. As we have seen across other developed nations, there is no zero-bound for rates, and as of today, 25% of global investment-grade bonds trade at negative yields, including all of Germany’s government bonds.
Over the short-term, the impact would be similar to any regular decline in interest rates, which is prices of bonds would increase, creating price appreciation for current holders. It would be unprecedented in U.S. markets and would general plenty of headlines and chatter on the evening news and CNBC talking heads. However, market participants have gotten used to dealing with negative yields for several years now and do not think crossing the zero barrier would materially alter how the market functions or risks contained within it.
Over the long-term, as with any rate reduction, it impacts the longterm return potential of bonds. As everyone knows, the 30+ year secular rate decline helped aid bonds through a huge capital appreciation cycle. As the room for capital appreciation declines or is effectively eliminated, it is important to reiterate the position in which bonds play within a diversified portfolio. For conservative, income-reliant investors, it may require a shift in thinking and adjustments to financial plans to address future spending needs.
Another important, but overlooked viewpoint is that forecasting rates, even in the short term, are next to impossible, and these recent moves only reinforce that. For nearly a decade, we have heard everyone talking about normalization of rates and the inevitable march upwards. Bonds help serve as a ballast in a diversified portfolio as well as less correlated return streams, which are essential positions to play in portfolios.
Key Points
Fed announced an emergency rate cut to 0% to 0.25%, a $700B bond-buying program, and additional measures to make capital available to institutions and businesses impacted by COVID-19.
The Fed’s emergency actions were significant and may play a large role in helping stem further economic deterioration and help speed up the recovery but remains inadequate to help stabilize financial markets.
While we may see negative yields in the US, it would not impact our models any more than a similarly sized yield reduction would and, in our view, should not be a trigger for any further measures.
If you have additional questions or support items, please reach out. Be safe and smart.