The Fed’s Emergency Rate Cut in Context
The Federal Reserve cut its benchmark interest rate by 50bps in response to the coronavirus scare that represents an evolving risk to the economy. It was the first emergency rate cut between meetings (held eight times per year) since the 2008 financial crisis.
Can an emergency rate cut do anything?
Lowering interest rates in an economy won’t cure disruptions to global supply chains or help improve demand-related issues.
But what a rate cut can do is protect against the negative feedback loop we saw when the coronavirus news hit the stock market some 16 percent peak to trough in February.
When stocks went down to fears of lower growth, gummed up supply chains, and lower forward activity, this caused people to have to sell assets to raise cash in order to meet margin requirements. This caused stocks to fall further, which required additional selling to raise cash, and so on.
When investors are leveraged long and positioning in equities is stretched, to go along with other technicalities that can exacerbate a sell-off (e.g., short volatility positions), it can get out of hand and have a negative influence in the real economy. People and entities become worth less when the stock market falls and causes them to tighten up their spending.
Getting cash another 50bps cheaper can help get cash flowing back into financial assets. Companies can also better service their obligations when their liabilities become cheaper to help compensate for any virus-related slowdown. This can help avoid financial conditions from tightening excessively and help attenuate the effects of that on the economy.
Can an emergency rate cut “scare” the markets and make things worse?
Stocks dropped sometime in the hours after the announcement, but that doesn’t mean that the markets were “scared” because of the emergency rate cut.
50bps of Fed easing was priced in the day before. SPX is still around 3,000. If you take the effective duration of stocks (17.5) and multiply that by the effective shift in rates – assuming parallel and one-to-one feed-through into corporate funding costs – that would be another 8.5-9.0 percent lower. That’s around 2,735 [3,000 * (1 – (17.5 * 0.5) / 100)].
Holding all else equal, the rate cut will help. But it’s not a cure-all to offset the various exogenous factors that can adversely affect the stock market on a day to day basis.
Is this emergency rate cut temporary?
They can raise rates back up if the coronavirus risk abates. But the curve prices in more rate cuts going forward. So, seeing policy snap back to where it was after a temporary easing seems unlikely.
The future path for rate cuts can always be found on the CME Group’s website. It prices in another 1-2 25-bp rate cuts for the remainder of the year.
This is also why the logic of “holding interest rates steady to avoid running out of policy room” isn’t very good. The term structure of the forward interest rate path is already priced into all financial assets.
If they choose a different path relative to what’s already discounted into the market, then that has an influence on asset prices. If they stay tight relative to the market (even if that means easing, but not easing enough), then that’s a problem for asset prices.
Being too tight relative to what the market discounted is why almost all financial assets were down in 2018.
The recognition of this fact let to the snapback in financial asset returns in 2019.
How much do asset prices matter for the economy?
The financial system and the economy are inseparably tied together. The financial system provides the money and credit that drive spending. Money and credit are the substance behind what drives demand for goods, services, and financial assets. The price of anything is a function of the money and credit spent on it divided by the quantity.
Economic movements are influenced by markets interacting with each other and are always in the process of finding their equilibrium levels. Economies are constantly shifting the demand for goods, services, and financial assets such that nothing can stay supremely profitable or unprofitable for long.
When a good, service, or financial asset stays profitable over a long enough period, the quantities of it produced and the competition to produce it will increase and work to eliminate the excess return. If it is unprofitable, then the economics of investment will change such that the opposite process will occur.
For example, when a company’s stock prices goes up, they are more likely to issue more of it for additional funding, or use it as a “currency” to help fund merger, acquisition, and other corporate activity. When a company’s stock price goes down, they are more likely to buy back shares to decrease its quantity and help support its price on the market.
Economies function because people are trading goods, services, and assets that they have for goods, services, and assets that they want or want more of in relation to their appeal. The same is true in the financial markets. Cash competes with bonds, which compete with stocks, which compete with real estate, and so forth, based on their relative risk premiums. Investors want to be compensated for taking on more risk.
The size of the spreads between cash and other forms of assets will help drive how much money and credit will move where and drive that capital through the financial system. Most of these decisions are made by financial intermediaries (banks, non-bank lenders, hedge funds, traders, etc.) who are trying to grab this spread as a source of income. This process works to drive credit growth, the returns of various asset classes (e.g., cash, bonds, equities, real estate, private equity), and economic growth.
Interest rates back at zero – eventually – is a foregone conclusion
Interest rates will eventually be back at zero at the front end of the curve or even negative in the US. We’re entering a long period of stagnation with the high levels of debt to income.
Raising rates is guaranteed to put on the brakes because of the way it has a disproportionate effect on debt servicing. Global GDP is about $90 trillion. With the coronavirus’s impact on activity, growth isn’t likely to come in to previous expectations.
Credit markets are about $300 trillion deep. That means if you raise interest rates by even one percentage point, that’s an extra $3 trillion in annual debt servicing, taking the average. That’s over 3 percent of global GDP, or right around the rate at which it’s current growing. The world can’t tolerate all that extra debt servicing requirements. Instead of spending and investing, a massive amount of capital would need to go into paying down debt.
This has made interest rates more or less a one-way bet over the past year-plus, particularly as central banks got around to the idea that they not only wouldn’t be able to normalize interest rates, but would need to turn back to easing after a 12-18 month tightening cycle.
Inflation hasn’t been a problem and isn’t likely to pick up due to the cyclical factors (a tightening labor market) being swamped by the secular disinflationary influences (e.g., high debt loads relative to income, offshoring and automation, diminished role of unionized labor, and cheap capital incentivizing more firms to compete based on market share rather than price).
When rates are maxed out around zero or somewhere below zero, central banks turn to quantitative easing, or asset buying. But liquidity and risk premiums are already compressed, so QE won’t have as much influence, at least no where near its previous influence.
With asset buying, the central bank buys securities from private financial institutions and in the process creates excess reserves. The seller of these assets (the private sector) will be motivated to buy something similar to what they had previously owned.
So, there is a long chain of events before the wealth effect from higher asset prices flows into spending in the real economy. Accordingly, asset buying has produced a big divergence between goods and services inflation (low) and financial asset inflation (high) over this past cycle.
Making interest rates negative will make cash a little bit less attractive and buying assets will make bonds a little bit less attractive. But it’s not going to drive investors and savers to buy the type of assets that will help finance spending in the real economy.
Asset buying can push asset prices somewhat higher, but investors and savers will still be inclined to save and lenders and borrowers will still remain cautious in the deals that they make.
There’s a limitation to how much further stimulus the rates and bond channels can help create. They’re at or approaching those limitations throughout the developed world. The coronavirus scare has only accelerated the inevitable.
Eventually central banks are going to have to go beyond that into tertiary forms of monetary policy like yield curve control, monetization of fiscal deficits, or putting money directly in the hands of consumers and tying it to spending incentives.
Essentially, they’re going to need to get around the bond market as a constraining force to carry out their policy objectives.
Final Thoughts
The coronavirus is a disruption in an already fragile economy and market. The economy is entering a prolonged slog everywhere in developed markets, which have productivity growth rates of only about 2 percent or a bit lower, and flat to negative growth in their worker populations. This includes the US, developed Europe and Japan.
The virus has also impacted the developing south Asian economies, which are growing at 3-7 percent. These countries are well embedded in global supply chains, especially in consumer goods and technology.
Your third main sphere are the cyclical emerging economies – e.g., Brazil, Turkey, Mexico – which are growing at higher rates in nominal terms, have a bias toward easing monetary policy, stabilizing balance of payments situations, and positive real rates and quality premiums on risk assets.
In developed markets, the future looks scary because of not only the high debt to income ratio, but the non-debt obligations – e.g., healthcare, pensions, and other unfunded liabilities – that are many multiples of the debt figure (depending on the discount rate used to capitalize those liabilities).
In the US alone, looking at the debt maturities coming due over the next 5+ years, the US Treasury is going to have to roll over a lot of debt, up to 25 percent of GDP. Not only will a lot of new debt need to be issued (5-10 percent of GDP) but a lot will need to be rolled over to keep the government funded.
There’s always the assumption that this won’t be an issue. The Fed can essentially coordinate with the US Treasury and buy up the excess bond supply – i.e., the Fed is independent from the fiscal arm of the government and can recognize this brewing problem on its own.
A lot of US Treasury debt is owned by foreigners. It comprises a bit over 60 percent of global FX reserves. But now that US yields are catching down to those of the rest of the developed world in Europe and Japan, the demand for that debt isn’t going to be the same.
On top of that, major owners of US Treasury debt, such as China, are in conflict with the US over a host of issues, including trade, intellectual property, forced technology transfer, government subsidies, market access, market competition, global spheres of influence, cyber-espionage, and related sub-categories.
Moreover, the motivations between domestic and foreign buyers of debt are different.
A domestic buyer cares about the real return of the security – i.e., what’s the rate of inflation and how does that compare to the nominal return, with the difference being the real return. The higher the real return the better. When the real return is lower, they’re more likely to look to something else, either riskier form of credit or stocks if the risk premium is good enough, or another safe haven asset like gold.
A foreigner buyer cares about the currency. If they’re getting a 1 percent nominal return on a bond, if left unhedged, just a one percentage point adverse move in the currency would wipe out the entirety of the annual yield of that bond.
The US’s financial issues – with a burgeoning fiscal deficit, large external debt position (45 percent of GDP, which isn’t sustainable long-term), and various forms of non-debt liabilities that are many times the size of the headline debt figure – mean that there’s inevitably going to be a problem.
To avoid this from spilling into the interest rate channel – i.e., higher bond supply decreasing the price and raising the yield – the Federal Reserve is going to have to buy this excess supply.
This means they’re going to have to “print money” (a lot of it) to keep things going. This will shift the matter into the currency channel. In terms of the size of the Fed’s balance sheet, we haven’t seen anything yet compared to what we’re going to see over the next 5+ years.
Between a choice of two unattractive options:
(i) Letting interest rates rise – and derail economic output through high debt servicing requirements and the adverse effect on asset prices by letting the discount rate rise to decrease the present value of cash flows, and
(ii) “Printing currency”
…the Fed will inevitably print.
This is bad for the US dollar going forward. But it’s a question of bad relative to what?
Other developed markets have these same set of issues in some form. So, that doesn’t necessarily mean the euro, yen, and so on are necessarily superior currency options over the long-run. But it probably means that having gold in a small portion of your portfolio can be a good idea.
Gold acts as the inverse of money in that its price is proportional to currency and reserves in circulation relative to the global gold stock. Currency and reserves in circulation are going to inevitably grow faster than the supply of gold. This doesn’t mean gold is going to do well over the next day, week, month, or year, but there are large secular forces in place that make gold a viable part of a portfolio going forward.
As for the central bank printing money, it can help mitigate the influence of the precarious financial situation developed market sovereign governments find themselves in. But it’s much like a pyramid scheme because all they’re doing is exchanging one liability (debt and debt-like obligations) for another (new currency and new debt).