Market Extra: Why stocks tanked despite the Fed’s emergency rate cut

The stock market tumbled Tuesday, with investors apparently rattled rather than comforted by the Federal Reserve’s decision to deliver a rare, emergency rate cut aimed at shielding the economy from disruptions caused by the global spread of COVID-19.

Read: Fed cuts interest rates by half percentage point in rare intermeeting move

“I think the Fed’s rate cut backfired in many ways. Instead of soothing the market, it’s reignited investors’ worst fears,” Michael Arone, chief investment strategist for State Street Global Advisors, told MarketWatch in a phone interview.

Stocks initially jumped after the Fed announced a half-point cut, but gains proved short-lived. The Dow Jones Industrial Average

DJIA, +2.19%

 fell nearly 1,000 points at its session low and ended the day down 785.91 points, or 2.9%, at 25,917.41, while the S&P 500

SPX, +1.89%

 dropped 2.8% and the Nasdaq Composite

COMP, +1.83%

lost 3%.

Meanwhile, investors piled into safe-haven assets, including Treasurys, driving the yield on the benchmark 10-year note

TMUBMUSD10Y, -1.96%

 below 1% for the first time ever. Yields fall as debt prices rise.

Check out: What history says about stock-market performance after emergency rate cuts

What gives? Here’s what analysts and investors are saying about the Fed decision and the market reaction so far:

Fears that things may be worse than they look

While an interest-rate cut was good for a knee-jerk positive reaction in equity indexes, gains soon faded as the initial euphoria gave way to questions about just how worried policy makers must be to prompt such a rare move. It signals to investors “that policy makers are grasping significant uncertainty and rapidly mounting downside risks,” said Lara Rhame, chief U.S. economist at FS Investments, in an interview.

Wrong medicine for a supply shock

There is also the longstanding question of how effective monetary stimulus, and even some forms of fiscal stimulus, can be in the face of what is likely to be a “supply shock” — the type of economic hit caused by the absence of goods and services as the virus forces factory shutdowns and curtails transportation and travel. Monetary and fiscal stimulus is typically aimed at mitigating demand shocks, which are sharp cutbacks in spending by households, businesses or governments.

Earlier: The Dow keeps getting slammed by fears coronavirus will deliver a supply shock central bankers can’t fix

Also see: The Fed can’t stop coronavirus from slamming the economy, but it could ease the pain

“A supply shock to the economy isn’t helped by global rates right now,” said Art Hogan, chief market strategist at National, in an interview. That said, there are concerns a supply shock will spill over into a demand shock as well, Hogan noted, and the Fed’s move appears aimed in part at providing insurance against that possibility.

Spotlight on fiscal policy

To the extent that policy makers can respond to the potential for an eventual demand shock, pressure will likely mount on politicians to provide a fiscal boost, potentially in the form of temporary tax cuts and other measures. That is even more the case outside the U.S., where major central banks, including the European Central Bank and Bank of Japan, have all but exhausted room for additional monetary easing, analysts said.

“I think the Fed is now saying we did the monetary side and it’s time to get the fiscal side involved,” said Leslie Falconio, senior strategist at UBS Global Wealth Management, in an interview.

Bond proxies in demand?

The usual defensive sectors — utilities, consumer staples and real estate — were outperforming the broader stock market Tuesday. But with the 10-year Treasury yield below 1%, yield-hungry investors will be even more hungry for bond proxies to generate needed income, Arone said.

“Low rates are only going to exaggerate that demand, so utilities, REITs, staples — your classic high-yielding sectors — will be in greater demand regardless of their valuations or their business prospects just due to the fact that yields are so low,” he said.

Paying the price for ‘perfection’

Investors will likely remain at the mercy of headlines surrounding the spread of COVID-19 in coming weeks and months, but “there’s no doubt that equities have been way too complacent over the last several quarters,” Rhame said.

While last week’s lurch lower saw major U.S. stock indexes tumble from recent records into correction territory, investors had looked past slowing earnings growth, deteriorating revenue growth, margin compression and signs of moderating economic growth over the past year-and-a-half, she said.

How much of the market’s downturn “is closing the gap between fundamentals” versus a reaction to the coronavirus threat is very unclear right now, she said, but it is clear that of all financial markets, large-cap equities were previously “priced for perfection.” While investors will hope for some stabilization in equities, it seems clear that the low-volatility environment that prevailed in the final quarter of last year is gone.

“It’s all about managing volatility,” she said.

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