Fed’s cut: shot in the air, how soon UST yields to fall below 0%?

Key takeaways 

The Federal Reserve slashed interest rates by 50 bps to 1-1.25% in the first such emergency move since the 2008 subprime mortgage crisis. In addition to the cut on its benchmark overnight borrowing rate, the Fed also announced a half percentage point cut on the interest it pays on excess bank reserves. The IOER is used as a guardrail for the fed funds rate.

We believe that unlike the Fed the markets underestimate economic risks, which are far from being priced in. Under our pessimistic scenario, the volatility will stay in the near future, UST yields will fall below 0% until the end of April, gold will test $1770/oz and RUBUSD will continue to weaken to 70. The Fed's rate-cutting cycle is likely to end in September at 0%. If the volatility picks up in line with our forecast, further cut is possible at the March 17-18 meeting. UST 5Y and of longer maturity purchases are likely to be in full swing by the second quarter. Even if a vaccine against the virus is developed, which is unlikely to happen sooner than September, pandemic’s cumulative impact on the economy will add pressure on the markets. The Bank of Russia will stay on track to gradually cut rates by 25 bps at a time due to global volatility. We maintain our forecast of the key rate cut to 5-5.25% by the end of 2020.

Our forecast table

Source: ITI Capital, Bloomberg

Why did the Fed change its stance and delivered a sharp rate cut at the extraordinary meeting?!

• Essentially, the Fed is close to rebooting the rate cycle, a move which seemed ridiculous several months ago, as the market and official institutions, including the IMF and the OECD, were expecting the economy to pick up in 2020 globally, in particular in developing countries (DM) such as Latin America (LATAM) and Southeast Asia (SEA) - in India and other countries except China
• Many countries were expected to return to growth or to hold rates, including in Russia (tight neutral monetary policy stance). As soon as the coronavirus began to spread outside China in late January, triggering a massive stock market rout on February 21, the environment changed dramatically, wiping $6 trln off global equities, according to the Bank for International Settlements (BIS) data. The U.S. and major banks of the G7 countries have teamed up as Marvel comics heroes to save the global economy. The Fed’s governor used a liquidity bazooka to make a pre-emptive strike on March 3, but the scale of the crises is not clear yet and the things will only get worse
• Overall, this is certainly an unprecedented move in response to an unprecedented crises - the number cases officially exceeded 95,000, deaths - topped 3100. The virus has been spreading exponentially in Italy, South Korea and Iran. On Wednesday, there were at least 126 known cases in the United States, as the US death toll climbed to nine. The pandemic is expected to spread rapidly across India, Africa and Latin America
• The OECD slashed its 2020 global economic growth forecasts to 2.4% from 2.9%, markedly revising down prospects for China and India. Since 2018, recession indicators have been flashing signs of an economic slowdown
• We are at the beginning of the cycle, and the worst is yet to come for the economy. The magnitude and persistence of the overall effects on the economy, remain highly uncertain, but the regulator’s key goal is to take steps to support the economy, which is happening now, and to counter chain disruptions using all available monetary policy tools, Jerome Powell’s said at a press conference. The Fed we will continue to closely monitor developments and their implications for the economic outlook, and to act as appropriate to support the economy

Why the Fed’s move is a shot in the air?

• From July 2007 to December 2008 the Federal Reserve cut the rates from 5.26% to 0%, driving the market up fivefold during continuous 10-year growth cycle. However, back then the rates were the highest since 2000, and after the bubble burst additional liquidity was needed
• The markets are being cured using the conventional methods, only this time they faced a disease of a new type. This time around are no issues with liquidity, and initially there were geopolitical and economic problems that later will lead to financial problems and lower efficiency of stimulus measures, as the crisis is only starting to unfold. This time around are no issues with liquidity, and initially there were geopolitical and economic problems that later will lead to financial problems and lower efficiency of stimulus measures, as the crisis is only starting to unfold
• It’s only the beginning of the first stage of economic crisis (no impact assessment is yet available), which will be followed by the second phase (the financial crisis proper, i.e. asset dislocation), and as soon as investors determine the bottom, the recovery will begin. This scenario won’t unfold if a vaccine is developed now, at the early stage of the epidemic, and the epidemic is completely localized, but this is still unlikely
• Companies have used cheap liquidity to invest additional funds into production and supply chains; the consumers, in turn, have received cheaper funds to generate new demand
• Consumers didn’t need additional funds (due to record low unemployment and strong income growth) neither before the coronavirus outbreak, nor need them now, and companies have accumulated record amount of cash on their balance sheets
• The problem now, therefore, is not a lack of supply and demand drivers, but of security guarantees. Simply put, it is impossible to drive consumer demand if there is a threat to their lives, as well as to the companies’ security. Thus, QE will be effective only if the coronavirus is localized
• So, of course, we will have a rally, but only after the epidemic is over, and for now the markets will fall further. The financial authorities are trying to cure the markets using money, not the real remedy, the way they did it back in 2008. It works if the economy's engine is down, but in our case the problem is the driver, who is physically restrained. On top of QE, we expect tariffs and tax cuts, although all fiscal stimulus will be rolled back. We forecast a V-shaped recovery, but we have not yet reached the bottom, which should happen before steep rebound

How soon UST yields will drop below 0%?

• Under our baseline scenario, the Fed will keep cutting to the key rate to 0.25% in 2020, making smaller cut at a time at the upcoming meetings. 50 bps cuts in June and September are also possible at the scheduled meetings, if the situation deteriorates
• After rates will drop to 0-0,25% quantitative easing package will be announced i.e. purchases of UST 10Y or longer notes and increasing the Fed's balance sheet, which has not changed much and amounts to $4.185 trln, i.e. down by only $300 bln due to purchases of short treasuries
• Ultimately, not later than the end of April, under the pessimistic scenario, the yields of the UST 10Y will follow the Eurozone notes and drop below 0% for the first time on records, which will certainly weigh on the dollar, as it will significantly lower the dollar appeal as a carry-trade asset and improve the appeal of EM currencies with high rates, such as the rouble, Mexican peso, Turkish lira, etc.
• We believe that the vaccine will be launched in the market no sooner than September 2020, which inter alia is in line with the White House forecasts. Coronavirus will spread rapidly till the middle of 1H20 and, ultimately, the implications for the economy will be seen in the March macro statistics to be released in April and in the first quarter earnings reports

US Key Rate and US Treasuries performance

Source: Bloomberg, ITI Capital

US Key Rate and S&P 500 performance

Source: Bloomberg, ITI Capital

Lower rate to drive demand for gold

Source: Bloomberg, ITI Capital