Fed Makes 50bp Emergency Cut. What's Next?

On Tuesday, the Fed took the lead in delivering stimulus with a bang, only a few hours after it had participated in a joint statement from G7 central banks which attempted to assure markets that “all appropriate policy tools” would be employed to support growth.

By announcing an inter-meeting 50bp rate cut, the Fed slashed the Fed Funds rate from the previous range of 1.50% - 1.75% to a new range of 1.00% - 1.25%.

Importantly, the Fed’s messaging suggests that this is not a “50bp and done”. In his press conference, Fed Chairman Jay Powell stated that the risks from the outbreak to the US growth outlook has “changed materially” and that the Fed was “prepared to act appropriately.” Judging from history, this language from the Fed against a backdrop of an external growth shock and low inflation suggest a bias for more cuts ahead as the Fed assess incoming data relating to the outbreak.

In the event that the outlook for the virus outbreak unexpectedly improves, the Fed would retain the optionality to go on hold. But if the trajectory of the outbreak and economy continues to deteriorate in the weeks ahead as per our base case scenario, we believe it is possible that the Fed would make one to two more 25bp cuts in its scheduled meetings in March and April.

We see global central bankers taking the Fed’s cue. The Bank of Canada has cut its overnight rate by 50bp to 1.25% after the Fed's move. The Bank of England can be expected to cut rates by 25bp to 0.50% when it meets on 26 March.

The BOJ and ECB has less policy space to ease than the Fed but will be under pressure to follow the Fed’s lead. Over the next few months, the BOJ could potentially cut rates by 10–20 bp deeper into negative territory and increase asset purchases but their hope would be that fiscal action from the government can take the lead. The ECB would focus its measures on easing credit tightness for corporates under stress from the virus outbreak and potentially more asset purchases and marginal rate cuts to the tune of 10-20 bp if foreign exchange pressures arise.

In the aftermath of the Fed cut on Tuesday, the US equity markets first rallied but quickly lost its gains, closing the session down about 3%. This reflects the view that monetary stimulus is a blunt tool against a medical crisis which appears poised to cause a sharp economic shock in terms of reduced consumer expenditure and production disruptions.

That said, monetary easing can help at the margin by supporting aggregate demand, for instance through savings gained via mortgage refinancing, and also offsetting the deterioration in financial conditions and sentiments.

In the aftermath of the Fed cut, we also saw the dollar easing against major peers. As the Fed has more scope for conventional rate cuts ahead versus major peers, we see the scope for moderating dollar strength - typically a positive factor for emerging markets.

Even accounting for policy responses from global central banks and governments ahead, we see significant scope for market volatility as the outlook for the virus and economy deteriorates as anticipated, and we expect near-recession growth in the second and third quarter of this year before a recovery in late 2020 and after.

Our neutral stance towards equities reflects prudence in this uncertain environment; although we believe it is too early to buy this correction, our base case is that the virus outbreak would not derail the long-term economic expansion.

While the outbreak is escalating, investors should avoid areas of clear risk, for instance, industries such as travel, hospitality, restaurants, offline retail and entertainment.

As rates continue to fall, we see the search for yield continuing to be a structural driver of markets. We recommend switches from poorer quality assets into selective quality dividend-yielding stocks, such as Singapore REITs. Additionally, investors should monitor closely for opportunities to switch into companies with solid long-term fundamentals that have sold off into bargain levels but should emerge relatively unscathed from the virus outbreak.

It is also critical that investors build up portfolio resilience through active diversification and explore incorporating hedges into their portfolios, which can include positions in precious metals and safe haven currencies.