Insight & Analysis

The return of rate cuts

Published: Mar 2020

With countries around the world continuing to face turmoil as a result of the Covid-19 pandemic, corporate treasurers will be paying close attention to the impact on financial markets, and to the fiscal support being implemented by central banks around the world at this challenging time.

Stock market digital graph

“Financial markets have been in a tailspin for the last few weeks as a result of increased uncertainty surrounding the short and long-term economic effects of the coronavirus outbreak,” says Sander Van Tol, Partner at treasury advisory firm Zanders. “The nervousness on the financial markets has been further increased by the power play between Russia and Saudi Arabia on oil prices and production.”

As Van Tol explains, with increasing volatility in the financial markets and a flight to safety, “This market reaction is quite similar to the liquidity crisis of 2008. Equity markets are hit by plunging share prices, and bond prices in fixed income markets have increased as a result of the sharp decrease of interest rates over the whole yield curve.” He adds, “The primary debt capital markets have ground to a halt, leaving borrowers wondering when they will be able to print new issues.”

Central banks take action

In light of the ongoing crisis, a number of central banks have taken action in the form of interest rate cuts. Measures adopted in recent weeks include the Federal Reserve’s decision to cut the federal funds rate to 1%-1.25% on 3rd March, as well as rate cuts by the Reserve Bank of Australia (RBA), Bank of Canada and Norges Bank, Norway’s central bank. On Sunday 15th March, the Fed cut rates further still to a target rate of 0% to 0.25%. “It also communicated other wide-ranging actions to support financial markets, including additional asset purchases, expanded repos, and a credit facility for commercial banks to support lending to US households and businesses,” says Van Tol.

Also notable was the Bank of England’s decision last week to slash interest rates from 0.75% to 0.5%. while also loosening requirements for banks to hold capital buffers – a move which Paul Dales, chief UK economist at Capital Economics, said would free up an extra £190bn for banks to lend to businesses. As Van Tol explains, the BoE has also “decided to offer banks four years of funding at the new rate plus a fee in order to support lending during the coronavirus crisis and the period thereafter.”

“The Bank of England’s package is a strong one that should help the economy through a period of short-term weakness and speed the subsequent recovery when it comes,” comments Rob Wood, UK economist at Bank of America. “The measures can help alleviate the extent to which economic weakness spreads into business distress, especially the financial policy actions.” Wood also points out that monetary policy is only one part of the jigsaw, noting that targeted fiscal stimulus from Chancellor Sunak “will be important especially for the short term.”

Many treasurers will be feeling a sense of déjà vu in light of these measures. The 2008 financial crisis likewise prompted a series of interest rate cuts around the world – although rates were considerably higher before the crisis, giving central banks more scope for taking action. “So far, the ECB has not cut their interest rates yet,” says Van Tol. As he points out, the ECB “is stuck between a rock and a hard place in this respect: official Eurozone interest rates are at minus 0.5% already, so there is hardly any room to manoeuvre.”

Impact of rate cuts

Fed Chair Jay Powell has noted that a rate cut “will not reduce the rate of infection or fix a broken supply chain” – and as Van Tol points out, the effects of coronavirus are driven by demand shock in real markets, which cannot be repaired easily by financial market measures.

“On one hand, you can explain the rate cuts by the Fed and BoE as a clear message that they will do whatever it takes to support the financial markets and the economy,” says Van Tol. “With the rate cuts they show they are decisive and want to support economic growth.” However, he adds that the Fed’s two consecutive “in-between rate cuts” can make people “fearful that the markets must really be in bad shape, which exacerbates the volatility and nervousness. One thing you do not want is that markets panic even more.”

Van Tol says the effect of the interest rate cuts will be limited for corporate borrowers. “Looking at the current interest expenses of corporate borrowers, we see that in many cases the credit spreads on loans are higher than the underlying reference rate,” he says. “So an interest rate cut will more than likely be offset by an increased credit spread.”

Meanwhile, from a corporate treasury point of view, he says it is “of the utmost importance” that there is sufficient liquidity in the markets. If liquidity in capital markets were to diminish as a result of nervous markets, he says, “this will trigger a direct effect on credit spreads and new issuance premiums for corporates. But the first priority for corporate treasuries is to get access to liquidity, especially now debt capital markets are not functioning.”

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