Fed’s latest surprise rate cut may signal a global problem

Wall Street loves it when the Federal Reserve cuts interest rates. But Wall Street hates it when the Fed cuts rates in a panic.

The latter was the case over the weekend when Chairman Jerome Powell cut the rates the Fed controls down to zero and took other actions to deal with the coronavirus outbreak that threatens to overwhelm the US.

The fact that the Fed cut interest rates is probably the least significant thing it did.

As I’ve been writing, the Fed really had no choice but to bring down borrowing costs because the bond market had already done so. The Fed was merely following the market’s lead and getting back some semblance of its control over rates.

What was shocking is that the Fed brought rates down by a full percentage point just a week after it had already cut by half a percentage point. And now, with Fed rates effectively down to zero, Powell no longer has that weapon in his arsenal.

Also shocking — and not unnoticed in the investment community — is the fact that Powell felt compelled to cut rates just days before the Fed policy meeting, which begins tomorrow.

What was so urgent to cause a cut in rates on a Sunday night? Why couldn’t the action have waiting until Wednesday afternoon when investors would have been more prepared? That, after all, is when the Fed traditionally makes moves.

That gets us to the more significant part of what the Powell did on Sunday — something called “dollar swaps.”

That’s simple enough to explain.

Banks somewhere else in the world are having financial problems. My bet would be banks in Germany and Italy are especially vulnerable. And “dollar swaps” allow the Federal Reserve to send money to these banks to keep them afloat and not cause their problems to become ours.

Powell brought this up in his Sunday press conference. “Because of the importance of the US dollar in the global economy, strains in the market for borrowing and lending dollars overseas can disrupt financial conditions here in the US,” Powell said. “To guard against such disruptions, the Federal Reserve maintains swap lines with five major central banks.”

The Fed chairman said he was reducing “the pricing on our dollar swap lines.”

Whenever you do something like this you don’t want to tip your hand as to which banks in which countries are in trouble so Powell mentioned that these dollar swap discounts were being done with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank.

But you can bet the real problem is being experienced by the European Central Bank, which was already dealing with a weak economy in a number of countries even before the virus panic began.

The Fed also announced that it was doing another quantitative easing, or QE. That was the panicked money-printing response to the Great Recession.

Started under Fed Chairman Ben Bernanke, then followed up by Janet Yellen when she took over, Powell tried to undo QE in 2018.

Quantitative easing was an effective way to rescue the financial markets from collapse in the early days. But printing trillions of dollars in new money did little to boost the economy, although it did create financial assets bubbles.

The low rates also forced ordinary investors to abandon bank accounts and dive into the stock market, where returns — up until recently — were stunning.

Now Wall Street is seeing the other side of the financial bubble that Bernanke and Yellen created and that Powell was unable to control.

In fact, Powell’s Fed has been doing massive numbers of overnight repurchase agreements (repos) — which put liquidity into banks — for months before the virus hit. That shows the Fed was worried about banks even before this latest crisis.

Now the Fed is doing more repos and another QE — a massive one involving $700 billion — and someday, maybe someday soon, the financial markets will start to worry about the inflation the printing of all that extra money will cause.

The financial markets read Powell’s downbeat mood quickly on Sunday.

Stock futures were down the 5 percent limit overnight Sunday into Monday. And when stocks opened Monday in New York, the losses were nearly 10 percent. The Dow Jones industrial average at its worst on Monday was down about 2,800 points, or about 30 percent, from its peak.

As I mentioned in a column on Feb. 25, what the Fed had been doing to interest rates over the past decade had caused a bubble in the stock market. In fact, it’s fair to say that many people thought stock prices could never fall.

Now investors have quickly been brought back to reality.

In that Feb. 25 column, I mentioned that the price of earnings (PE) ratios of stocks was about 19 to one. That means the per-share price of stocks was 19 times greater than the earnings, on a per share basis, that was expected of companies.

The historic average PE ratio for stocks is 14.8 to one. So stock prices when that column ran were about 23 percent overvalued.

In other words, the stock market would have had to fall 23 percent to get prices back to the historic norm.

So, now that the market has fallen significantly from its high, is it safe to buy stocks? Well, probably not. And here’s why.

The other part of the PE equation has to do with the earnings expected by companies. And with coronavirus causing a panic worldwide and shutting down many businesses, it’s clear that the earnings per share part of the PE calculation will also come down.

And Wall Street expectations for earnings is still probably too optimistic.

According to Refinitiv, which tracks company earnings, Wall Street expects earnings for the 500 companies in the S&P 500 index to be up only 0.4 percent in the first quarter of 2020 — the current quarter.

But Wall Street’s expects earnings to bounce back to 1.7 percent gains in the second quarter and zoom after that with 6.9 percent gains in the third quarter and 9.4 percent gains in the final quarter of this year.

And that would be great — except that nobody really knows when the virus panic will end and whether the damage already done will be that transitory.

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