Is zero Fed fund rate a comforting or worrying signal?
Worrying it might be, but there is more to watch out for
17 Mar 2020 | Aaron Leung
Graph 1. Fed Funds Rate
Graph 1. Fed Funds Rate

JUST one week after the oil price plunge, the Federal Reserve announced on March 15 another cut in short-term interest rates by 100bp to 0-0.25%, bringing it to almost zero, and launched its US$700 billion quantitative easing (QE) programme.

Last Sunday's rate cut also follows a rare move by the Fed on March 3 when it cut the Fed Funds rate, the benchmark for short term interest rates, to a range of 1%-1.25% in what Fed chairman Jerome Powell said was intended to provide a boost to the US economy in response to the “evolving risk” of the coronavirus pandemic.

Normally in a low rate environment, issuers benefit from a lower borrowing cost and fixed income investors rejoice amid a strong injection of liquidity. Yet, this time primary purchases are subdued and secondary trading is shallow.

The reason is risk aversion which is suppressing the primary market volume. A sellside executive in one of the major bond houses revealed that the “primary (market) will be stagnant, for a while, and cash is king.” The executive says that there were very few deals in recent weeks and most of them did not do well.

Risk-off trades are also prominent in Asia’s secondary bond market. The ten-year US treasury yielded at 0.6% range at Asia time on March 16 (as of this writing), dropping from 0.95% on March 13, according to Bloomberg data. It closed at US$105 on March 13. It rose to as high as US$108.33 (Asia time) on March 16.

Some traders are saying that emerging market debt is definitely in trouble, with a sellside sales trader who witnessed some foreign outflow from emerging market sovereign debt, saying “the moves are almost like during GFC (global financial crisis)”. However, the market is still far from a meltdown.

Still Asian investors are not entirely bearish in the mid to long term. “I don’t think it will be a world crisis,” claims a fixed income investor sitting on some Chinese property credits. “The high-quality names will still perform, so in one or one-and-a-half year’s time this will be a good point to pick up some less risky names.” At the same time, local currency bond investors are not necessarily switching to US treasury because of its mandates.

Moreover, the recent selloff has been too rapid to be reasonable which may imply that algorithmic trading, not active investors, are behind the market downturn.

Going forward, with central banks running low on ammunition, investors are watching closely to see if central banks would coordinate their efforts to achieve maximum results. However, it is uncertain whether international cooperation will likely take place as “America first” tops the US agenda and Steven Mnuchin, the Treasury Secretary of the US, believes in “a big rebound” later in the year, diverging from the market views.

An economic slowdown is certain, however. Stalled by Covid-19 and a full-board contraction for China’s industrial output, investment and retail sales appear as expected. China's fixed-asset investment tumbled 24.5% year-on-year in the first two months of 2020. Industrial production and retail sales in China plunged 13.5% and 20.50% respectively year-on-year in January-February 2020.

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