History suggests where zero interest rates and big spending may leadExcerpts from the 5/15/20 edition of Fidelity Viewpoints. Access the full report here.
Since economic activity began to shut down amid concerns about the spread of COVID-19, the federal government has committed to spend trillions of dollars to try to offset the impact on businesses, consumers, municipal governments, and financial markets. In response, stocks have risen, liquidity has increased in bond markets, and volatility in many markets has fallen.
The longer-term impact this massive policy response will have on markets and the economy remains unknown. To get a suggestion of how deficit spending and low rates might shape the future, though, we can look at how similar policies have shaped the recent past.
- Since the global COVID-19 pandemic began, the Federal Reserve has lowered interest rates and bought financial assets to stimulate economic growth and help markets operate smoothly.
- The federal government is also spending trillions of dollars on economic stimulus, adding to record high national debt.
- The potential long-term impact of these government policies on inflation and economic growth will be an area of focus in the future.
- For now, inflation is not a near-term concern, due to the drop in demand for goods and services around the world.
Monetary stimulus: Good for stocks
As the global financial crisis unfolded in 2008, central banks around the world cut interest rates and purchased bonds to stimulate economic growth, increase liquidity in financial markets, prevent deflation, and avoid a second great depression.
While growth eventually recovered in most countries and industries and prices of assets such as US stocks rose to record heights, many financial crisis-era policies were never abandoned. In some cases, such as the European sovereign debt crisis in 2011 and 2012, policymakers expanded these policies to include purchases of a wider variety of assets and even the adoption of negative interest rates under which investors effectively paid central banks for the privilege of lending money to them.
Stocks have benefited from unconventional monetary policies. The recovery of the S&P 500 that accompanied the revival of asset purchases, liquidity injections, and interest rate cuts since March echoes its performance following the financial crisis. In March of 2009, the S&P began what would become a record-setting bull market after the Fed cut rates to between zero and 0.25% and began adding what would eventually be trillions of dollars’ worth of liquidity into the financial system.
But while central bank interventions support stocks, they also contribute to a more modest outlook for bond returns, uncertainty regarding long-term inflation, and greater risk-taking by investors. Due to these policies, the total global value of bonds with negative yields rose from zero in 2015 to $17 trillion in 2019. These negative and low yields on high-quality bonds that traditionally attract savers have pushed conservative investors into stocks and higher-risk, higher-yielding bonds.
Besides setting super-low rates, central banks are making large-scale purchases of not only government but corporate bonds, even some with below-investment-grade credit ratings.
These bond purchases also raise questions about whether inflation will eventually result from governments injecting more money to fund continued asset purchases.
Fidelity Managing Director of Research Lisa Emsbo-Mattingly believes investors need to account for risks from both inflation and deflation. “The long-term ramifications of extraordinary policies are highly uncertain, but we see a rising probability of an unprecedented regime shift in economic growth, inflation, or both,” she says.
The US government’s fiscal and monetary policy response to COVID-19
|Policy initiative||Billions of dollars||Multiplier||GDP Impact|
|Cash to individuals||290||1.9||3%|
|Aid to state and local governments||150||1.8||1%|
|Public health spending||340||2.3||4%|
|Loans to small businesses||376||1.9||3%|
|Tax relief for businesses||232||0.3||0%|
|Targeted industry support||78||1.1||0%|
|Risk capital for Fed activities||454||N/A||N/A|
Lars Schuster, Institutional Portfolio Manager with Strategic Advisers LLC says, “For now, we have very few concerns of inflation being a near-term concern for the economy, due to the drop in demand for goods and services. But the potential long-term impact on inflation will be an area of focus as we emerge from the pandemic.”
How low for how long?
Does the expansion of central bank balance sheets and government spending mean the US will follow Europe and Japan in keeping rates near zero or even negative?
Fidelity Sector Strategist Denise Chisholm says, “Rates in Europe have a higher probability of being negative, given the higher probabilities of deflation. This can impact the US as well, through increased demand for Treasuries, but the extreme level of stimulus relative to the rest of the world may decrease the likelihood of permanent deflation and negative rates in the US.”
But while negative rates may be unlikely in the US, higher rates that would benefit savers may be unlikely as well. Emsbo-Mattingly points out that central banks have already struggled trying to unwind their extraordinary policies and raise rates. “The Fed’s interventions into markets have reinforced investors’ perception that central banks will routinely provide liquidity to quell volatile markets,” she says.
This increased spending comes after the Congressional Budget Office (CBO) had forecast the government would spend $1 trillion more than it would collect in taxes in 2020. That deficit would have represented roughly 4.6% of total US GDP, but the CBO now estimates virus-related spending will push that number to $3.7 trillion or 17.9% of GDP in 2020 and $2.1 trillion or 9.8% of GDP in 2021.
Opinions vary widely about how dangerous deficits are. One controversial but increasingly popular economic philosophy known as Modern Monetary Theory* even holds that countries such as the US, whose currencies are not backed by assets such as gold reserves, are never at risk of defaulting on their debts because they can always increase the money supply.
Schuster says, “Longer-term, higher national debt may likely lead to slower growth and low interest rates, but we believe they are extremely unlikely to lead to near-term concerns on the creditworthiness of the US government.”
While the massive policy response is helping now, director of global macro Jurrien Timmer says it might have unintended consequences. “It could prevent a typical early cycle recovery from unfolding in the months ahead,” he says. “If businesses that would have otherwise gone insolvent during a recession survive through policy intervention, maybe the policy response perversely ends up muting the recovery.”
“Perhaps the price for all this intervention,” says Timmer, “is a post-COVID economy with slow growth and low interest rates. In that scenario, companies with strong balance sheets get rewarded, while financially engineered zombie companies survive but don’t thrive. Only the government’s footprint is much larger.”