Reaction To The Fed Rate Cut

At 10 AM this morning, March 3, 2020, the Federal Reserve announced it was cutting its policy rate of interest by 50 basis points.

As we covered yesterday, this was somewhat expected. But perhaps not to this degree and not with this amount of aggression. I estimated that the 0.25bps cut had an estimated 100% chance, and the 0.50bps cut had a 50% chance. 

So, suffice to say, today’s cut was somewhat of a surprise, even with the degree of certainty. 

That surprise translated to the market, which did not take it well.

Within a very short time, the yield on the 10-year US Government note dropped below 1.00 percent, a new historical low.

On Monday, all three major US stock indexes registered substantial gains after five days of large declines.

As we covered yesterday, the reason for Monday’s gains were attributed to how investors expected that the Federal Reserve and other central banks would soon cut their policy rates of interest in an effort to stem falling stock markets around the world that were reacting to the spread of the coronavirus and the global economic slowdown it was causing.

Laughable in some respects, but that was the primary narrative. 

Well, on Tuesday, the Federal Reserve acted and the stock market dropped!

Whoa! It wasn’t supposed to act that way! What’s going on?

The question has to be, what changed between Monday and Tuesday?

Let’s take a guess. My guess is that investors believed these moves would not come immediately. Because there had been a lot of talk that the Federal Reserve and other central banks would lower interest rates, the feeling was that they would not act immediately.

Thus, the move by the Federal Reserve surprised investors. Things must be worse than was thought.

Investors concluded that if the Federal Reserve felt it had to move as fast as it did, that things must be a lot worse than the investors had thought they were.

That is, the Fed’s move broke the market’s expectations about when a Fed move might be made. The investors, therefore, had to react.

US stocks declined on Tuesday, and not by just a little bit.

First off, the cut by the Fed was an overreaction, and the Fed should have waited longer to see if it was necessary when real economic effects were seen. They should not be reacting to stock market tantrums. Their supposed twin mandates are controlling inflation and unemployment, NOT protecting equities.

That said, with so many countries at or below 0%, I get the pressure to cut. Even at 1.25%, the US has higher rates than the entire Eurozone, which is at 0%. That’s wild.

All these nations getting so used to cheap credit and massive government spending are in for a world of hurt if rates ever need to rise.

And, here’s the thing: They can’t now, ever. The Fed tried to raise rates at end of 2018, 9+ years into a raging bull market and it failed spectacularly.

If they can’t raise near all-time highs in markets, then surely they will raise when there are actual struggles in the economy right? 

The answer to these cuts is only going to be more cuts in the future.

Two thoughts:

Again, dropping rates isn’t going to fix people not being able to go into the office and it will not encourage people to get on planes. The Trump administration needs to provide policies and stimulus to the country so we take precautions and are not afraid. That means things like providing test kits nationally, guaranteeing people won’t go into debt just by getting examined, providing thermal camera and hand sanitizer stations for public locations, etc.

The fed has been dropping by a quarter percentage point because they wanted to see the reaction each drop made, and now they suddenly drop by a half percentage point? AND they did it in between meetings? That is a statement. They must think this is very bad.

But here’s the big question raised by today’s actions: Is the economy worse off than expected? 

Up to now, the projections for the US economy presented by the Federal Reserve System seemed to be very reasonable. I used them on a regular basis because I believed that they were the most reasonable forecasts around.

Federal Reserve officials saw US economic growth coming in at 2.0 percent in 2020. The rate of growth dropped in 2021 to 1.9 percent and then fell to 1.8 percent in 2022. These rates of growth were not that robust, but relative to the rest of the world and given the fact that the unemployment rate in the United States was at a fifty-year low, analysts seemed to feel that things were alright.

It was also the case that some economists, including myself, believed that the current way to measure the health of the US economy understated the actual health of the US economy. One major argument along these lines has been that businesses cannot find workers, especially smaller businesses were coming up short, when it came to filling job needs.

But, now, the Organization for Economic Cooperation and Development has put out new forecasts that have caught a lot of people’s eyes. The OECD now has put out a picture of the US economy producing a negative growth rate in the second quarter followed by a recession, possibly coming by the end of the year.

Investors have apparently taken the Federal Reserve action as a confirmation that the Fed now believes that US economic growth may be more toward the OECD outlook than its former position.

Let’s also consider that a supply-side slowdown is inevitable at this point. 

Can the Federal Reserve overcome the picture drawn by the OECD? Can it stop a recession from occurring?

The problem is that the economic slowdown connected with the spread of the coronavirus is a supply-side phenomenon. Monetary policy can do very little to offset a supply-side contraction.

So, if we have an economic slowdown and if the Federal Reserve can do very little to combat this supply-side slowdown, it appears, and this seems to be what the bond market is saying, that things are going to get worse, economically. The only thing the Federal Reserve can do is prevent a cumulative financial disruption.

Therefore, economic growth is slowing, and, along with this, expectations for inflation are also being reduced.

So, let’s talk about inflation.

Nominal bond yields are often separated into two components, expectations for the real growth of the economy and expectations about future inflation. I often analyze bond yields in this way.

To have the yield on the 10-year US Treasury note drop below 1.00%, says a lot about what investors in the bond market are thinking.

Inflationary expectations built into the 10-year Treasury note have dropped into the 1.50 percent to 1.60 percent range. This is after the range has remained in the 1.70 percent to 1.80 percent range for the past several months. Up to now, this expectation has remained relatively steady, indicating that investors expected future inflation to remain somewhere near 2.00 percent, the target objective of the Federal Reserve.

The numbers for the expected real growth rate for the US economy have been distorted because of the massive flow of “risk averse” monies flowing into the United States as international investors saw the US as a “safe haven” for their funds.

So, the important thing here, for me, is the fact that inflationary expectations have taken such a hit in the past week or so. This movement indicates to me that investors now believe that the Federal Reserve cannot really stop an economic slowdown. All the Fed can do is try and keep financial markets calm.

So, we are at yet another inflection point. All the crypto markets need to do is respond intelligently to these changes.