May 2020

The Reserve Cash Management composite continued to enjoy the benefit of spread tightening in May, generating a total return net of fees of 0.36%.  The characteristics of the composite changed little from the prior month and the average credit rate is A+.

The Federal Reserve executed their lender of last resort function brilliantly.  That is until the June 10th post-FOMC press briefing.  Prior to the meeting, the Fed had successfully engineered a comeback in stock prices, much to the dismay of institutional investors and hedge funds, that missed the rally.  We previously outlined the steps the Fed has taken to date, with the most recent policy change coming to the Main Street Lending Facility announced just days ago.

What spooked the market on June 10th was the Summary of Economic Projections (SEP), also known as the dot plot.  The forecast presented a unanimous view that the Fed would not need to raise the overnight interest rate until at least 2022, with several members believing that the current Fed Funds rate will remain in place well into 2022.  For better or for worse, market participants believe the Fed has superior information in terms of what’s going to happen in the market.  The logic flowed that if the Fed sees interest rates unchanged for the next two years, then the state of the economy must be worse than had been feared.  The rally in the stock market over the last six weeks has been premised on the United States being close to ending the shelter-in-place policy and a corresponding rebound in economic activity.  With that belief, analysts were upgrading their earnings forecasts and the hope that higher stock prices were justified.

To compound the unwelcome forecast, Chairman Powell did little to calm investors as he addressed the media.  Unlike his predecessors, Chairman Bernanke and Chair Yellen, Powell has developed a reputation as a commanding, inspiring speaker.  However, that man didn’t show up for the press conference.  He waffled on how long interest rates would stay at current levels and what in the economy would prompt the committee to change their mind.  Granted, asking an economist to answer questions on a Covid-19 virus is not entirely fair.  Moreover, the zoom-like social distancing format for the press conference likely caused him some unease.  The format, like the last, had journalists calling in from remote locations resulting in some difficult to understand audio and caricature-like broadcast of the participants.

Also concerning to us, but seemingly lost on the general market, is the Fed’s consideration of yield curve control.  The concern is that the as the economy normalized, interest rates would rise and that could impair any nascent economic revival.  Investors suffered through a similar occurrence in May 2013, in what has been dubbed the “taper tantrum.”  To avoid a recurrence, the Fed is considering establishing a predetermined level at which it would step in to suppress rising interest rates.  As with so many of the Fed ideas for managing the economy, they seemed to be contrived without adequate thought as to what will happen when they need to be reversed.  Recall, the Fed has the dual mandate of full employment and stable inflation.  By definition, yield curve management by capping interest rates further limits the Fed’s ability to tackle inflation should it arise quickly. 

Initially, stocks reversed from their high of the day, but after sleeping on the news, investors decided their pre-meeting assumption that activity would bounce back was wrong.  On the day after the meeting, the S&P 500 plunged more than 4%, with the Bank and Finance sector falling nearly 10%.  It will be interesting if equity investors again climb the wall of worry emboldened by the belief that the Fed will bail them out if economic circumstances disappoint.

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