COVID-19: What Shocked Financial Markets?

Professor Anna Cieslak dissects the March stock market crash and the Fed’s unprecedented actions

September 10, 2020

When the S&P 500 index lost nearly a third of its value in the first quarter of 2020, it was clear COVID-19 was the catalyst.

Although the crash was caused in part by investors’ downgraded economic outlook, research from Anna Cieslak, an associate professor of finance at Duke University’s Fuqua School of Business and faculty research fellow at the National Bureau of Economic Research, suggests that economic uncertainty and heightened risk aversion played an even bigger role in the decline

In a live discussion on LinkedIn (video above), Cieslak deconstructed what caused financial markets to crumble, and how aggressive action by the Federal Reserve helped restore investor confidence in the spring.

Cieslak sought answers in the events surrounding the 2020 market crash by applying a model she first developed in 2019 with Fuqua Ph.D. candidate Hao Pang in a paper titled “Common Shocks in Stocks and Bonds.” She analyzed market movements including announcements from the Fed and Congress in late March of unprecedented measures to support the economy.

Cieslak considered the markets’ response to these events and calculated that, of 30-point drop in the S&P 500 index from the beginning of the year through March 23, about 10 percentage points could be attributed to investors downgrading their expectations about economic growth. 

Almost twice as much – about 18 percentage points – was due to an increase in the risk premium required by investors in the face of uncertainty about economic outlook. This triggered a flight-to-safety and exacerbated the initial decline in the stock market, she said.

“In addition to reflecting expectations, financial markets also reflect fears or risk aversion of market participants,” Cieslak said. “Both of these components are important. But uncertainty and risk aversion had about twice the impact. The uncertainty was huge, and that’s what led to what we call a ‘flight-to-safety,’ or people dumping risk assets in favor of safe assets, and this exacerbated the declines that we observed.”

She also evaluated the Fed’s response to the market crash. In an initial analysis, Cieslak concluded that when the Fed cut interest rates to zero in March, it counteracted about 4 percent of the decline in the S&P 500 index.

However, the most significant impact the Fed had was not in cutting interest rates, but rather in reducing risk premia, or renewing people’s confidence and appetite for risk, by a promise to stimulate the economy, buying Treasury bonds, intervening in credit markets, and consequently nearly doubling its balance sheet from $4.5 trillion in assets to more than $7 trillion in just a few weeks, she said.

“It looks like the Fed has, in combination with the fiscal stimulus, been successful in averting some of the economic decline,” Cieslak said. “Obviously, a lot of open questions remain – what will be the consequences of these bold policy moves in the longer term, and how bad will 2020 be in terms of GDP growth… The uncertainty about outlook and consequences remain very significant.”

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