The possibility of a Fed Rate cut to stabilize the markets may move mortgage rates higher not lower.
Right now rates are at a 4 year low, due to a flight to quality, as fears of the Carona Virus continue to weigh on the markets.
“When money flows out of stocks and into Bonds, the price of Bonds rise, while inversely the Bonds rates drop, making mortgage rates more attractive.” says John Sauro of North Atlantic Mortgage.
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The Federal Reserve May Need to Step in COVID-19 poses downside risk to the U.S. economy, and though there are limits to monetary policy, the Federal Reserve may need eventually to step in. An emergency rate cut is unlikely, as these are rare. The most likely outcome is that the Fed continues to wait and see how financial market conditions fare and whether the coronavirus is having significant direct or indirect impacts on the U.S. economy. However, we are not ruling out that the Fed could act. Investor sentiment needs a boost, and normally investors turn to the Fed, anticipating a “Powell put.” The term “Powell put” isn’t as ubiquitous as either the Yellen, Bernanke or Greenspan puts. The idea of a Fed put garnered attention in the 1980s and 1990s under former Fed Chairman Alan Greenspan. Setting a floor Derived from the concept of a put option, these terms refer to central bank policies that effectively set a floor for equity valuations. Fed Chairman Jerome Powell seems less sensitive to stock prices than some former chairs, but he recognizes that a substantial decline in equity markets could alter the outlook for the U.S. economy. So, a Powell put exists, but equity prices likely have not fallen enough to trigger it. The Fed likely viewed the stock market as being a little frothy—we agree.
We constructed several valuation metrics and compared them with actual stock prices. Each metric is constructed as the fitted values from a linear regression of stock prices on a proxy of fundamental value, including GDP, corporate earnings, and discounted free cash flow, measures that capture earnings and interest rates.
All these metrics showed that the stock market was overvalued. While the selloff in the stock market may not worry the Fed, credit markets could. The Fed can stop credit markets from freezing up; and that is one way to protect the economy. The Fed’s objective would be to prevent a supply-side shock, like coronavirus, from spilling over into the demand side of the economy.
We are watching high-yield corporate bond spreads, which are widening, but it will have to continue before it sounds alarms at the Fed. Odds on the FOMC We will be revisiting our subjective odds of a rate cut for the rest of this year’s Federal Open Market Committee meetings. While monetary policy has its limits and cannot cure the coronavirus, the Fed is not powerless. If financial market conditions continue to tighten, odds of a rate cut will increase. The Fed has shown that it will respond more quickly to an inversion in the yield curve, and a rate cut could help bolster investor sentiment. It may not cure all that troubles in financial markets, but it could help. Still, we believe the key is not equity but rather credit markets.
Making sure credit markets don’t freeze is critical. The impact of the coronavirus on U.S. GDP will be less than in China. The hit to the U.S. economy will come via reduced US goods exports to China, less spending in the U.S. by Chinese tourists, and a drop in domestic production because of supply chain disruptions. We expect this drag on the U.S. economy to be 0.45 percentage point on first-quarter GDP growth, but this is likely a little optimistic, particularly given the supply chain impact and evidence the virus has spread beyond China.
The U.S. economy will experience growth of only 1.3% in the first quarter (annualized), down by 0.6 percentage point because of the virus. Growth in 2020 is now expected to be 1.7%, down 0.2 percentage point. The U.S. economy’s potential growth is estimated at near 2%. Our previous assumption that the virus will be contained to China proved optimistic, and the odds of a pandemic are rising. We previously put the odds of a pandemic at 20% (see our Alternative Scenario), but we now put them at 40%. A pandemic will result in global and U.S. recessions during the first half of this year. The economy was already fragile before the outbreak and vulnerable to anything that did not stick to script. COVID-19 is way off script. COVID-19 came out of nowhere. It may be what economists call a black swan—a rare and inherently unforeseeable event with severe consequences.
Source: Moodys