Do we have too much faith in the Federal Reserve?

Has the Federal Reserve come to the rescue too many times and provided investors with a false sense of security?

Has the Federal Reserve come to the rescue too many times and provided investors with a false sense of security?

There is an adage on Wall Street — don’t fight the Fed. What does that mean exactly? In my three-decade career in financial services, it has always meant that the Federal Reserve will bail out the stock and bond markets through monetary policy. When the markets got in trouble, the Federal Reserve would simply cut interest rates.

Falling interest rates is a signal to investors to buy stocks. Typically, an interest rate cut spurs consumer spending, making it more affordable for Americans to borrow money to purchase such big-ticket items as homes, automobiles and appliances. This spending drives business revenue and profit and encourages investor confidence. A drop in interest rates also makes it cheaper for businesses to borrow money for expansion and growth – providing investors with another reason for optimism.

As a result, we often see the Fed jump in to ease investor nerves. It worked in 1987, when the stock market crashed due to higher interest rates and program trading. Fed Chairman Alan Greenspan cut interest rates, causing the bond market to rally and the stock market eventually followed. The subsequent rebound only took a few months.

In contrast, the financial crisis of 2008 was caused by the failure of the subprime loan market and the near collapse of major U.S. banks. Yet, monetary policy again helped save the day. Ben Bernanke, who was Federal Reserve Chairman at the time, rapidly cut interest rates, but also instituted a quantitative easing program, enabling the Fed to buy large amounts of distressed debt that nobody else would buy. Ultimately all these steps worked, but it took several years for the stock market to recover.

Fast forward to today, and one could argue that the coronavirus pandemic has caused an even greater financial pandemic. Unemployment has skyrocketed, industrial production is down and some oil futures are actually negative. This could be the greatest economic crisis to hit the nation since the Great Depression.

In response, current Fed Chairman Jerome Powell has not only cut interest rates to zero but is using the Fed’s emergency lending powers to restore confidence in the financial markets. He is doing this by buying back treasury bonds, guaranteeing money market funds and buying investment-grade corporate bond exchange traded funds (ETFs). The Fed is also backstopping the Paycheck Protection Program which is encouraging banks to lend to companies that keep their employees employed during this crisis.

The stock market was down 37% as of March 23 from the highs hit in February but has since rebounded 25% based on the belief that the economy will have a quick V-shaped recovery and that the Federal Reserve will do everything it can to save the markets.

Currently, investors believe Federal Reserve intervention is working because the stock market has stabilized and is now at the higher end of a recent trading range. However, it is hard to believe the worst is over for the markets, considering the millions of unemployed Americans, no earnings guidance from U.S. companies for the foreseeable future and a massive drop in oil prices.

Wall Street is betting trillions of dollars on a quick recovery for the global economy and that Americans will shrug off the pejorative effects of the coronavirus and resume their regular activities. From my vantage point, it appears that getting back to “normal” will be a lot harder and take much longer than investors are expecting today.

Let us hope I am wrong, and that the Fed can help alleviate the pain of this process quickly.

Categories: Business Insights, COVID-19, Finance