The Fed has finally opened its crisis-era playbook and announced on Sunday that it is cutting its benchmark interest rate to zero and launching a new round of quantitative easing. It reminded us of the 2008 initiatives taken by the central bank — the only difference being that the Fed had to act pretty fast this time to contain the coronavirus outbreak.
The latest QE program will involve $700 billion worth of asset purchases, entailing Treasuries ($500 billion) and mortgage-backed securities ($200 billion). The Fed is scheduled for meeting on Mar 17-18. Before this, the U.S. central bank cut the target range for its federal funds rate by 50 bps to 1-1.25% during an emergency move on Mar 3 (read: Emergency Fed Cut Less Effective: ETFs That Should Survive).
The latest round of cuts will bring short-term rates down to the range of 0% to 0.25%. Previously, the Fed cut the rates to this level in mid-December 2008, which was the 10th rate cut in more than a year’s time.
However, such steadfast action by the central bank may fail to stem the market rout as stock futures spiraled down on the Fed announcement, at the time of writing.
Why Markets May Not Cheer Fed’s Action
Like many analysts, we believe a global economic slowdown is caused by a “supply shock” — the absence of goods and services amid virus-led decline in productivity, city lockdowns, factory shutdowns, restrictions on travel and cancellation of events.
Monetary policy easing is less likely to help such issues as this kind of central bank measures are normally meant to boost demand. Plus, the latest rate cut was largely priced in Friday’s market rally (read: Low Volatility & Quality ETFs Stay Strong Amid Market Rally).
Then, there has been coordinated fear about the upcoming global recession. Markets are likely to plunge more when the virus-infected downbeat economic data will start coming in. No one knows the bottom in the market yet.
Goldman Sachs predicts an almost 10% fall in the S&P 500 over the next three months, to 2,450. If these were not enough, President Trump has now declared national emergency to fight coronavirus.
Against this backdrop, we highlight a few ETFs that are under the spotlight.
Banks underperform in a low-rate environment. Financial Select Sector SPDR Fund (XLF - Free Report) lost about 56% in 2008. What will happen in 2020? It depends on the yield curve movement. The Fed action has dragged down short-term bond yields this month. If risk-on sentiments improve in the market, long-term bond yields would rise, resulting in a steeper yield curve, which is a positive for banks.
But if there is more fear in the market, safe-haven trade may keep the long-term yields low, hurting banks further. Also, amid economic slowdown, there could be a rise in delinquency rates, affecting banks’ asset quality.
U.S. Treasury Yield
It’s clear winner amid a low-yield environment. iShares 20+ Year Treasury Bond ETF (TLT - Free Report) and iShares Short Treasury Bond ETF (SHV - Free Report) may gain from safe-haven demand and low Fed rates. Notably, TLT gained 28.3% and SHV added 0.7% in 2008. In the past 10 days (as of Mar 13, 2020), TLT is down 0.8% and SHV is up 0.4%
Investors should note that a decline in rates has actually boosted mortgage refinances of late. Higher volume and “increased risk to mortgage investors from all those refinances” are resulting in slower decline in mortgage rates than the treasury yields. In 2008, the fund iShares MBS ETF (MBB - Free Report) added 3.1%. In the past 10 days, the fund is down only 0.6%.
Though utilities perform well in a low-rate environment, Utilities Select Sector SPDR Fund (XLU - Free Report) may not give the desired performance this time around due to the supply-shock scenario and national emergency. In 2008 as well, XLU was down 31.4%. Still, due to its safe-sector status, selloff may be comparatively lower in it. XLU is down 7.2% in the past 10 days, lower than the S&P 500-based SPY’s 8.1%.
This sector benefits from low rates. The sector can emerge as a true safe haven amid the latest crisis as even people on self-quarantine need daily essentials.In 2008 as well, Consumer Staples Select Sector SPDR Fund (XLP - Free Report) lost just 17.1%. In past 10 days, it has lost just 2.3% (read: Beat Virus With 2 Sector ETFs & Stocks That Survived 2008 Crisis).
This cyclical sector actually may win from low rates despite not being a rate-sensitive sector. The sector is loaded with stay-at-home stocks like Facebook (FB - Free Report) and Twitter (TWTR - Free Report) . In any case, the tech-heavy Nasdaq-100 ETF (QQQ - Free Report) (down 5.7%) has been less affected compared to SPY in the past 10 days. Big tech stocks are cash-rich too and thus may counter any crisis with more ease. Technology Select Sector SPDR Fund (XLK - Free Report) is off only 4.7% in the past 10 days (read: Forget Virus Scare, Buy Tech ETFs on the Dip).
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