FAQs: Emergency Interest Rate Cuts — Will They Work? Do They Matter?
Question: Why are central banks taking emergency measures by cutting interest rates?
The first and simplest step is to understand the mandate of central banks. Their remit is to ensure the market operates with economic and financial stability. They look at all available information, primarily focusing on keeping inflation in check and minimizing unemployment. Under this lens, during moments of market panic—like today—where economic and financial conditions are less stable, we should expect central banks to act.
Their main tool to fight against this instability is interest rates, where they can alleviate the pressures on households, companies, and even the government, by reducing rates. They can also get inventive, as they did in the Global Financial Crisis, by injecting additional stimulus into the financial system. Whether that is so-called “quantitative easing”, “helicopter money”, or otherwise—they are looking for levers that help promote economic and financial stability.
For example, the Federal Reserve has recently agreed to purchase another $700 billion worth of Treasury bonds and mortgage-backed securities. They also struck a deal with five other foreign central banks, the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank, to lower their rates on currency swaps to keep the financial markets functioning normally.
Most recently, the Reserve Bank of Australia has cut rates to a record low of 0.25% and will start a program of what is known as quantitative easing, for the first time in Australia’s history, which involves buying government bonds. The aim is to keep a lid on borrowing costs and support the economy.
Whether central banks get it right is one thing, but how an investor ought to respond is quite another.
Question: Are these emergency measures a good or a bad thing for investors?
On balance, it is probably a positive for long-term investors, although it can be hard to see when in the eye of the storm. That is, people tend to get a bit anxious when authorities like the Federal Reserve recognize the challenges in the environment, but—all else being equal—investors should see it as a positive when central banks make it clear that they’re proactively addressing the situation. For instance, the rate cuts could be beneficial to the speed and magnitude of the recovery.
The other positive is the fact that this is coordinated with other central banks, although the situation is quite different from one country to the other and requires different sets of measures. It is a bold move, for sure, but they’re making it very clear that they will play their part to keep the economy and the markets functioning. Again, this doesn’t guarantee it will work, but it is certainly better than a disconnected or passive approach.
One last point on this—financial markets are complex. The short-term market moves are highly unpredictable. They will undoubtedly be influenced by central bank action, but fear and greed will play a more prominent role amid the uncertainty. It is the long term we care about though.
Question: What might the central banks know that we don’t?
Let’s face it, the central banks don’t have a crystal ball, just like investors don’t have a crystal ball. Central banks do have access to an abundance of timely and accurate information. They also have many smart minds to analyse this information. But they can’t know something that is unknowable.
There is little the central banks can do if the economic activity stops because people can’t work, travel, shop, go out, and so on. What they can do is to try and limit contagion or secondary effects by:
- Keeping credit available to households and businesses, and
- Keeping markets functioning by providing liquidity to all market participants, keeping borrowing costs low, and trying to limit market financial stress which tends to work in vicious cycles as we saw during the GFC of 2008/09.
Some of the measures introduced recently are targeted at key elements of well-functioning global financial markets (such as the currency swap lines). This could have a dramatic impact if liquidity dries up.
This relays back to our original point. If we focus on the mandate of central banks, we should not be surprised that they are looking to stimulate against a great unknown. That is their responsibility. Our responsibility as investors is quite different. We need to think much longer term. We are looking at all the cashflows we expect an investment to deliver over its lifetime, then ideally pay a cheap to fair price for those cashflows.
Question: Will the rate cuts factor into portfolio positioning?
At Morningstar Investment Management, we are looking for two things during these times: risk and opportunity. From a risk perspective, we are dealing with the same unknowable that central banks are. We can be quite confident that coronavirus will be a historical memory 10 years from now, but we have little idea of what might happen tomorrow or three months from now. This is why we diversify, keep costs low and seek underpriced assets.
That said, we must also seek opportunity. On this occasion, market participants are sceptical that interest rate cuts will help the situation and/or are becoming worried that the central banks have little stimulus left to provide. During these times we have an opportunity to do what others can’t or won’t—to see opportunity amid the madness.
What does that mean exactly? Well, at a minimum, we calmly seek to rebalance (an approach that phases the selling of bonds, which typically do well in times of uncertainty; in favour of buying unstocks); and with the material declines we have seen in some sharemarkets, we have been a willing buyer amid the chaos.
It is important to note that we won’t know where the “bottom of the market” is. We can’t and don’t need to know that. However, we can focus on valuations and help our clients in growing their long-term wealth by buying assets for less than they’re worth and not panicking when everyone else is. We’d also like to note that “the market” is the culmination of several underlying markets. We take a granular approach to investing and will continue to analyse over 200+ asset classes from around the world.
To close, we leave the final word to the great Warren Buffett, which should be placed on everyone’s fridge during times like today:
“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.”
