The Fed cut interest rates to zero and will relaunch its QE program to protect the economy from the coronavirus

NEW YORK, NY / ACCESSWIRE / April 15, 2020 / Everybody agrees that the Fed’s interest rate decisions have had crucial implications in the investment world. As investment professionals, we feel it is necessary to take a moment to explain the mechanism behind the Fed’s monetary policies.

First, we’d like to introduce a renowned economic model – the Mundell-Fleming model. Mundell, known as the “father” of the Euro, is a Nobel Memorial Prize winner in Economic Science.

The Mundell-Fleming model concludes that an open economy cannot simultaneously maintain the following three conditions: 1) a fixed exchange rate; 2) free capital movement; and 3) an independent monetary policy. This principle is called the “Impossible Trinity” or “Mundell-Fleming Trilemma”.

Based on the Nobel Prize winner’s economic model, which is supported by both mathematical derivation and empirical evidence, we can infer a few trends with high conviction:

Lower global interest rates drive lower domestic interest rates

As global interest rates fall below a nation’s domestic rate, foreign money flows in to seek higher yield. The domestic currency, USD in this case, is in high demand and is pressured to appreciate. To offset the appreciation pressure that would threaten US exports, the central bank sells USD by injecting more liquidity into the market. As more USD is available in the market for borrowing, US interest rates enter a downward trajectory.

Lower domestic interest rates reduce the risk of an economic downturn in the US and the rest of the world

Lower interest rates make it more attractive for businesses to borrow to invest and for households to borrow to spend. Given investment and consumption are the two main pillars of GDP, lower rates usually stimulate economic growth. As the world’s largest economy in an ever more connected world, a healthy US economy reduces the risk of economic downturn in the rest of the world. An opposite example would be when the Fed started to reduce its QE program and hike interest rates after 2013, prompting a large amount of money to leave emerging markets. This was the so-called “Taper Tantrum” for the emerging markets.

Lower interest rates correspond with the outperformance of REITs

While bond yields are under pressure again as a result of the interest rate cuts, REITs have become attractive alternatives for fixed income investors. In addition to the decent cash flow, the value of real estate properties also rises as the risk-free discount rate falls – the smaller denominator in the discounted cash flow model.

How does it impact our portfolio allocation?

  • We have increased the duration of our fixed-income portfolio, a bet on falling interest rates.
  • Optimistic about REITs, we recently added AMT, a specialized REIT, to our portfolio.
  • Our portfolio company BX also owns a world-leading real estate business that continues to benefit from the low-interest-rate environment.

Destination Wealth Management is a firm focused on providing the resources necessary for you to successfully move towards your financial goals. Our qualified staff will work closely with you to develop a strategy designed specific to your goals.

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SOURCE: Destination Wealth Management

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