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March 03, 2020, marked a day of historical significance in the context of the bond market. After U.S. Federal Reserve's emergency rate cut, the benchmark 10-Year U.S. Treasury Yield, which is typically considered as the notional risk-free benchmark interest rate for global financial transactions, fell below 1%. The U.S. Federal Reserve delivered its first emergency rate cut after the 2008 financial crisis in order to restrict the long-term economic impact from the spread of deadly coronavirus.
However, the decision to exercise an emergency rate cut was not perceived well by the market. As after October 1998, emergency rate cut pushed the S&P 500 to gain above 50% in a period of just around 18 months. But that was widely criticised as a blunder that led to the worst Dot Com bubble burst. Â Meanwhile, an unprecedented rate cut in January 2008 at times when the global financial crisis was at its peak, was not able to curb the situation and the crisis extended further and global stocks gave up more than 50% in value before recovering.
Also, the initial signs of a recent emergency rate cut cannot be called favourable. And its effect is yet to be established. The primary intention behind this recent rate cut is to scuttle the financial pain that might make the economic impacts of coronavirus spillover less severe.
The day U.S. Federal Reserve announced this rate cut broader indices at the Wallstreet slumped approximately 3%. However, recovery was witnessed on the very next day as Dow Jones Industrial Average increased by 4.54%, Nasdaq Composite bagged approximately 3.85%, and the S&P 500 index surged 4.22%, respectively.
The day on which emergency rate cut was announced, globally, investors had a mixed response to the unprecedented 50-bps rate cut, which brought big swings in the stock market and other assets classes as well. The U.S. Federal Reserveâs decision of interest rates cut is an effort to safeguard the world economy from the impact of the coronavirus spillover, and Fed Chair Jerome Powell suggested that the threat to the economy would not be soon abated. Also, lower interest rates may increase the risk appetite and extend support to asset prices.
However, many experts perceive this unprecedent rate cut as signal that coronavirus cases in the United States are accelerating, which would have a major impact on the US economy.
However, theoretically, this move implies that now it is cheaper to avail credits that could support companies during economically challenging times and the lacklustre consumer spending. Also, a Lower interest rates make it cheaper for equity investors to borrow money to invest in stocks and other riskier assets, which indicates that flow of fund in the global equity assets would rise in the future.
However, there is no guarantee that this move would be completely able to curb the situation as, despite sharp rate cuts exercised in 2008, the market continued to fall for an extended period of time before a bounce back.
Emergency rate cut boosted gold prices
Precious metal âGoldâ recently got a solid boost from the United States Federal Reserve, with gold price expanding gains in Asia and international commodity market after the U.S. central bankâs emergency rate cut, as the deadly virus-driven rate cut led to a collapse in 10-year Treasury yields, to an all-time low.
Gold investors benefit from lower interest rates, and it can increase if there is more easing from the Fed and other central banks as policymakers seek to blunt the economic fallout from the health crisis.
Gold prices have surged more than 8.16% so far on a YTD basis over increased demand for safe-haven, with prices touching a seven-year high as holdings in bullion-backed exchange-traded funds expanded to a record. Fed policymakers pruned 50 basis points off their benchmark, cutting rates outside the normal cycle of meetings for the first time since 2008 has propped up gold prices in the bullion market.
How lower interest rate prop-up the equity market?
Interest rates are directly linked to the cost of capital, and it implies that lower the interest rate-lower the cost of capital and vis-à -vis. Also, during the time when the interest rate is lower one can't find the required yield on his investments, and investors open strings of their wallet to invest into more riskier investments so that they can get the required rate of return on their investments. Lower interest rates open the higher flow of fund into the equity market and increase demand for the stocks, which in turn derive the stock prices up. Hence, lower interest yields are called good for the equity market in the long run; however, with other conditions remaining the same.
However, price discovery of interest rates completely depends upon the level of supply and demand, if supply of money is in excess to the demand for it, one canât find the yield or return, because there is excess supply of money, but, if demand is higher than supply of money, yield will increase in long-run.
Normally, when Federal Reserve decreases policy rates, it has a consequent impact on the economy and it indirectly affects the stock market. Also, investors should keep in mind that the equity market's reaction to the policy rate adjustments is generally swift, whereas economy takes 6-months to 12-months to asses the broader impact of it.
Lower interest rates mean credit becomes cheaper, which in return boosts corporate earnings and send stock prices higher on stocks exchanges. However, in case of the banking businesses it acts adversely, lowers the interest rates implies lower interest income, which is the top line for the banking businesses and hence lower-earning which has a huge impact on their stock prices as well. Although, a lower interest rate could boost credit offtake, which would lead to an increase in bank's loan book, which carries the potential to completely offset the impact of lower interest rates on banks earnings.
However, for normal economic activities, a low-interest rate is boon, which boosts investments, production, employment, per capita income, which collectively fuel GDP growth.
