Emergency interest rate cuts—Will they work? Do they matter?

Q & A: Taking pressing questions and getting our in-house investment professionals to answer them in a jargon-free manner

Morningstar Investment Management LLC 25 March, 2020 | 1:18AM

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Question: Why did the Federal Reserve cut interest rates as an emergency measure?
The first and simplest step is to understand the mandate of central banks. Their remit is to ensure the market operates with economic and financial stability. They look at all available information, primarily focusing on keeping inflation in check and minimizing unemployment. Under this lens, during moments of market panic—like today—where economic and financial stability appears to be jeopardized, we should expect the central bank to act. Their main tool to fight against this instability is interest rates. They can alleviate the pressures on households, companies, and even the government by reducing rates. They can also get inventive, as they did in the Global Financial Crisis, by injecting additional stimulus into the financial system. Whether that is so-called “quantitative easing,” “helicopter money,” or otherwise—they are looking for levers that help promote economic and financial stability. For example, the Federal Reserve have agreed to purchase another $700 billion of Treasury bonds and mortgage-backed securities1 . They also struck a deal with five other central banks in Canada, the U.K., Japan, Switzerland, and the eurozone to lower their rates on currency swaps to keep the financial markets functioning normally. Whether they get it right is one thing, but generally the intent of these actions is to help the economy and investors.

Question: Are these emergency measures good for investors?
On balance, it is probably a positive for long-term investors, although it can be hard to see when we are in the eye of the storm. That is, people tend to get a bit anxious when authorities like the Federal Reserve recognize the challenges in the environment, but—all else being equal—investors should see it as a positive when central banks make it clear that they’re proactively addressing the situation. For example, rate cuts could have potential to help the speed and magnitude of recovery. The other positive is the fact that this is coordinated with other central banks, although the situation is quite different from one country to the other and each requires a different set of measures. These are bold moves, for sure, but the central banks are making it clear that they will play their part to keep the economy functioning. Again, this doesn’t guarantee these measures will suffice or won’t have unintended consequences, but it is certainly better than a disconnected or passive approach.

One last point on this—financial markets are complex and adaptive. The short-term market moves are highly unpredictable, where we suspect fear and greed will play a more prominent role amid the uncertainty. But it is the long term that matters for most investors, so we urge these investors to keep perspective of their horizon.

Question: What do the central banks know that we don’t?
Let’s face it, the central banks—like investors—don’t have a crystal ball. Central banks do have access to an abundance of timely and accurate information, though. They also have many smart minds to analyze this information. But they can’t know something that is unknowable. There is little the central banks can do if the economic activity stops because people can’t work, travel, shop, go out, and so on. What they can do is to try to limit contagion or secondary effects by: × Keeping credit available to households and businesses, and × Keeping markets functioning by providing liquidity to all market participants, keeping borrowing costs low, and trying to limit market financial stress which tends to work in vicious cycles, as we saw in 2008/09. Some of the measures recently introduced were targeted at key elements of well-functioning global financial markets (such as the currency swap lines). This could have a dramatic impact if liquidity dries up. But apart from these measures, fiscal policy might have the most direct economic impact, although that’s largely outside the scope of the central banks. This relays back to our original point. If we focus on the mandate of central banks, we should not be surprised that they are looking to stimulate against a great unknown. That is their responsibility. Our responsibility as investors is quite different. We need to think much longer term. We are looking at all the cashflows we expect an investment to deliver over its lifetime, then ideally pay a cheap to fair price for those cashflows.

Question: Will the rate cuts factor into portfolio positioning?
At Morningstar Investment Management, we are looking for two things during these times: risk and opportunity. From a risk perspective, we are dealing with the same unknowables that central banks are. We hope that coronavirus will be a historical memory 10 years from now, but we have little idea of what might happen tomorrow or even three months from now. For that reason, we diversify, keep costs low, and seek underpriced assets. That said, we also seek opportunity. On this occasion, market participants are skeptical that interest rate cuts will help the situation and/or are becoming worried that the central banks have little stimulus left to provide. Most stocks have fallen, many bonds have risen. During these times we have an opportunity to do what others can’t or won’t—to see opportunity amid the madness. What does that mean exactly? Well, at a minimum, we’ll calmly seek to rebalance (an approach that phases the selling of what we believe to be “safer” bonds in favor of buying beaten-down stocks) and if the market panic worsens, we will search for areas we think the market has mispriced on the downside. It is important to disclaim that we won’t know where the “bottom of the market” is. We can’t and don’t need to know that. We believe we can seek long-term profits for our investors by simply buying assets for less than they’re worth and not panicking when everyone else does. We’d also disclaim that “the market” is the culmination of several underlying markets. We take a bottom-up, granular approach to investing, so we will continue to analyze over 200-plus asset classes in our search for what we believe to be attractively priced investments. To close, we leave the final word to the great Warren Buffett, which should be placed on everyone’s fridge during times like today: “Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.

Opinions expressed are as of the current date; such opinions are subject to change without notice. Morningstar Investment Management shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use. This commentary is for informational purposes only.

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