Economic Outlook | May 2020

Fed Takes Fund Rate to Zero

The Federal Reserve has fired all its cannons by taking the fed fund rate to zero and purchasing bonds in the open market. This action added $2.5 trillion to the Fed’s balance sheet between March 1 and April 30, bringing the balance to $6.7 trillion – about 30% of the total annual U.S. gross domestic product.

What It Means for the Markets

This Fed action stabilized the bond market and brought some calming effects to the stock market. It may even have resulted in perhaps a bit too much stability as bond yields drifted lower, to levels that challenge investors who are trying to reconcile an acceptable level of return for their risk exposure in the bond market. The Fed does not care about valuation, as it simply “prints” money to purchase securities – whereas the rest of us purchase securities with money we had to earn and save. The difference in the two perspectives is as stark as the contrast between dark and light.

Theory vs. Practice

In theory, theory and practice are the same. But, in practice, they are different.

There are disconnects everywhere in the bond market. For simplicity’s sake, the Fed has a $106 bid for a mortgage bond that is similar to a secondary-market (already issued) bond offer that has a price of $103. This same bond would receive a secondary-market bid of $100. There is a 6% gap in market pricing depending on the source. This is the bond-market equivalent of those old stories about the military purchasing $400 hammers.

Where Do We Go from Here?

Great question! We listen to all sorts of interviews about reopening the U.S. economy and how all our troubles will soon be in the past. On the other hand, we see Associated Press polls in which 88% of respondents feel businesses should remain closed. I interpret this to mean that even if businesses do reopen, 88% of their customers will remain at home and may not patronize them for some time. There is a risk that fear will replace the virus as the primary impediment to the economy.

Government-mandated closures have been implemented with the goal of avoiding loss of life due to the pandemic. There are other perspectives, however. In the last 2 months, 30 million people applied for unemployment – each has “lost their life” as they knew it. Millions have lost their ability to provide for their families and pay for rent, food, clothing and utilities. Many have also watched their life savings, invested in their businesses, disappear. The pride, dignity and self confidence that come from earning your own way have been severely dented. We now read that 5 to 10% of small businesses will never reopen. A small business survey from the Society of Human Resource Management says that about one-third of small businesses say they could continue to operate for another 6 months, while 14% are uncertain and 52% expect to be out of business within 6 months

This Is Nobody’s Fault

Because this shutdown affected large swaths of previously employed people so suddenly, without regard for industry, sector or geography, there is a high level of solidarity among the newly unemployed – potentially leading to even more unprecedented government measures. To closely quote Winston Churchill, politicians will do the right thing – but only after everything else has been tried. After that, the questions will center around affordability and how it all gets funded.

Spillover to the States

States, counties and cities will not be spared. Income taxes will be down, sales taxes will be down, gas taxes will be down, and use taxes will be down. Oil states will see declines in extraction taxes. Property taxes should remain stable, if people can pay them. Many of these entities have balanced-budget mandates, so there is a good chance services will be cut.

The Model Response

State responses to the pandemic appear to be modeled around New York and New Jersey. It’s fair to say that much of the rest of the country leads a very different way of life. Many of us living elsewhere in the country don’t deal with packed subways or crowded sidewalks – or grabbing the same door handle and pushing the same elevator button as 58,000 other people going to the upper floors of high-rise office buildings daily. I personally can’t recall the last time I saw an elevator or a subway train.

The World Will Likely Keep Spinning

Before concluding that the world will soon stop spinning on its axis, consider that historically, it has been a poor wager to bet against the U.S. Things don’t look that great right now, and it looks like it will take longer than we all hoped to get the economy back on track. Between government stimulus programs and Fed market programs, though, it looks like there is a solid commitment to get through this. If your portfolio allocation was consistent with your risk/return profile before this started, don’t feel like anything needs to be changed. These words may be a bit more comforting today than 45 days ago, as the market has made positive strides forward since then.