On Tuesday, March 3, 2020, the world's financial markets watched in stunned silence as Federal Reserve Chairman Jerome Powell announced an emergency interest rate cut of 50 basis points to the Federal Funds overnight interbank lending rate. At the time the Fed Funds rate was at 1.75 percent and Dow Jones was trading at 26,703 points.
Within minutes, the Dow Jones would sink over 1000 points. Powell's emergency move would ignite the most volatile few weeks in stock market history, causing the market whipsaw in 1000-point swings up and down in the coming days. As the week ended, what had been the highest flying stock market in history was monkey-hammered down over 10 percent and the rate on the ârisk-freeâ 10-year Treasury had fallen to its lowest yield in history at nearly 0.3 percent. Unfortunately, this was just the beginning of a very long month.
President Trump, who for the first three years of his presidency had ridden the equity boom for all it was worth and had pinned his entire re-election campaign to the success of the economy in general and the height of the stock market specifically, seemed aloof to the situation. Weeks before, in February, he had enjoyed his highest ratings while in office as the stock market had boomed to all-time highs. On the night before the Fed's emergency announcement, Trump touted the American economy as the strongest economy in history and tweeted the following.
What did the Federal Reserve know that the president didn't seem to? An outbreak of a virus in China called Covid-19 had spread in pandemic fashion globally. While the virus had originated and expanded quickly in China, causing government leaders to shut down much of their country and disrupting the global supply chain, it was initially viewed by most of the rest of the world as remote and temporary. That perception soon changed as the coronavirus spread across Europe, Japan, South Korea, and the United States.
The Fed understood the severity of the moment. This was less because of the medical science and more because they quickly realized the virus could be the catalyst they'd long feared. The coronavirus could be the black swan that could expose the entire global economy for what it wasâa house of cards built on a mountain of debt, one that could collapse at any moment.
The immediate problem for the Fed was that the smart money was very aware of the economy's underlying weaknesses. For over a decade, the Fed had pumped liquidity into the system through a series of interest rate cuts and balance sheet expansions. Wall Street had taken full advantage. For over 10 years, CEOs and corporate executives had ridden the free-money elevator to the very top by taking on massive leverage and through stock buyback programs. The effect was a stock market that had risen to nosebleed valuations, completely untethered to underlying economic conditions. Stock prices had risen nearly 30 percent in the prior year while corporate earnings growth had turned negative for seven consecutive quarters. The annual chart displaying the trend lines between equities and earnings represented an âalligator jawâ that could collapse shut at any moment. The Federal Reserve hoped that the emergency cut announcement would signal calm to the market. The opposite occurred. On the announcement, Wall Street insiders, who had been looking for an excuse to exit, fled in unison.
This was definitely new territory. Over the course of the previous decade, the stock market had always reacted positively to additional Federal Reserve liquidity. What had often been bad news for the economy had been good news for Wall Street. The money changers realized that the worse the real numbers were, the more free candy the Fed would give away. The more âeasy money,â the bigger the sugar high and the higher the equity markets would rise. Anyone doubting that truth needed only look at the balance sheet of the central bank. Since 2009 anytime the Fed expanded their balance sheet, stocks soared higher. Any time their balance sheet contracted, stocks dropped precipitously. During this time, the phrase âDon't fight the Fed,â once a Wall Street insider secret, became the popular investment strategy for Main Street investors.
This time, however, was different. Immediately after their emergency cut, the economy began seizing. Anyone expecting markets to soar on the lower interest rate news was made violently aware that the game was over. The rate cut didn't help to soothe the market. Instead, the paper markets dropped like a rock. The Fed's next regular meeting wasn't scheduled for another two weeks, which meant that markets would likely have to wait for more sugar. Those who believed the underlying economy was strong were surprised by the speed of the selloff. Those aware of the massive debt bubble underlying the economy turned immediately bearish. They understood that markets could drop much, much further.
The term liquidity as it relates to the paper investment markets means that assets have both buyers and sellers on either side of a transaction. When there are more buyers than sellers, asset values rise; when there are more sellers than buyers, asset values drop. When everyone is selling and no one is buying, it's called a liquidity crisis. As markets cratered in the days after the Fed's emergency rate cut, liquidity in the credit markets completely dried up. The spreads between the bid and the ask on paper assets widened massively. The lack of liquidity meant greater volatility. The VIX, an index that measures volatility and had hovered at a price of $15 for much of the past five years, rose to $82. This violent move wiped out multiple hedge funds who had been shorting volatility and using massive leverage. Within days, stocks dropped over 20 percent, their fastest fall into a bear market in history. The move ended an 11-year bull run, the longest running bull market in history. Markets that had been roaring just weeks earlier plummeted. Further emergency actions would be necessary, and sooner than the Fed's next scheduled meeting.
Adding literal fuel to the fire of the liquidity crisis was what was simultaneously happening in the oil markets. A game of chicken had broken out between former OPEC partners Russia and Saudi Arabia in the form of a price war. Rather than agree to oil cuts, a standard policy tool of the oil cartel during a demand shock, the Saudi's decided to increase production and flood the world oil markets with supply. In one week, oil prices dropped 50 percent from $44 to $22 per barrel. The Saudi's upped their daily production from 10 million barrels a day to nearly 13 million. This increase in supply was happening as the world's travel industry was shutting down. The combination equated to a terrible shock in both supply and demand. The oil collapse put additional pressure on the world's equity markets. Conspiracy theorists wondered if the price war in oil wasn't an indirect attack on the United States by Russian President Vladimir Putin.
Whatever the underlying reality in oil, it was clear that the Federal Reserve would need to step in with far more aggressive action. A second emergency press conference would take place on Sunday, March 15, and was intentionally presented before the premarket opened. In a live conference call, a jittery Jerome Powell announced that the Federal Reserve had officially cut interest rates to zero percent. In addition, he announced that the Fed had taken several other measures to ensure that the credit markets would continue to function. Powell continued to insist that these actions were being taken to âkeepâ the economy strong.
The actions contradicted the rhetoric of a strong and well-functioning economy. Over the course of several press conferences and additional Fed statements after their first emergency action on March 3, the central bank offered a bazooka of liquidity. In addition to pushing rates down to zero, the Fed also announced the restarting of 2008 crisis-era policy asset purchases. It offered US dollar swap lines and eased banking rules to encourage lending. It announced longer-term Treasury purchases and repurchase operations amounting to more than $1 trillion to address what was deemed âhighly unusual disruptions in the Treasury financing markets associated with the coronavirus outbreak.â The moves did nothing to help the market. In fact, they further ushered in the collapse, as investors wondered what the Fed was seeing that they weren't.
The extreme actions were signaling a much deeper problem to Wall Street. The following day, the stock market endured its largest one-day drop since the 1987 Black Monday collapse, falling 12 percent in one trading session.
By March 23, the Dow Jones had fallen 37 percent from its highs just six weeks earlier. According to Bloomberg, the collapse would wipe out $26 trillion from the equity markets from their February highs, nearly triple the wealth lost during the housing crisis in 2008. Despite assurances from the administration and the talking heads on TV, investors sold first and asked questions later. As investors fled the markets, the plumbing of the entire system got clogged.
The stock market exchanges have âshut-offâ switches designed to stop the bleeding in a selloff. The action is called limit down, and anytime the market drops 7 percent or more during regular trading, or 5 percent in the after-hours market, trading is halted for 15 minutes. This collapse protection mechanism was added after Black Monday in 1987 when stocks dropped 27 percent in one day. They were...