Federal Reserve Cutting Rates.. Bandaid on a Broken Bone?

Buckle up, this is going to be a wild ride!

I think almost everyone is on the same page: the global market has seen some crazy volatility recently! World war 3 almost started in January, and February saw the escalation of COVID-19.. What does March have in-store for us? Rate cuts!

Before we dive into the recent news, lets lay down the fundamentals. When the economy slows down, it might need stimulation.. There are two strategies that the Federal Reserve can use to stimulate the economy.

1. Quantitative Easing:

This method of macroeconomic money management is attune to printing money. Its a very complicated process that can be simplified down to a couple transactions. Central banks (BoA, Wells Fargo..) purchase large amounts of bonds and other securities from the Government. Its an agreement between the two parties with one goal in mind: expanding the monetary supply, increasing liquidity and increase the velocity of money.

2. Altering Interest Rates:

Instead of creating money and exchanging it for assets, there is another strategy used to stimulate the economy. Lowering interest rates means there is a lower 'cost of borrowing' associated with borrowing funds. While this doesn't directly apply to the everyday consumer's credit card, it is behind the smoke and mirrors of commercial banking. Lowering of interest rates promotes spending, exchange, and overall increases the velocity of money. This is what is done when the economy is slowing down, and indicators suggest that stimulation is needed.

Adjunct:

It is very important to note that these are essentially the only two strategies that the government/federal reserve have to manage the intersection between 'the market', economics, and money. These two policies are largely untested, novel experiments with no long term data to back their validity. AKA: experimental.

What is going on now?

First, its important to note that the Federal Reserve did not want to get involved with the current situation, and "was going to monitor the situation closely.". Here is a more direct quote from the man of the hour: Jerome Powell.

This statement was made Feb 28th 2020, within the context of a gruesome week for the stock market. Trillions of dollars in value was erased from the global market cap, leaving investors and traders alike trembling in their boots. Someone had to make a move, but was this the correct one? Lets explore.

Current situation:

Lets get the facts straight:

  • COVID-19 is rapidly approaching a Pandemic with reported cases growing at an exponential rate. Although not particularly dangerous, the affect on productivity/GDP is the primary concern.
  • S&P 500/DJIA/Nasdaq were all grossly overvalued following many quarters of sustained bullish momentum. Analysts pinpoint 10-15% over-evaluation across the entire market. 
  • US Government is operating at the largest fiscal deficit ever.

Bandaids don't work for broken bones.

We're now going to dive into why the temporary fix of lowered interest rates does not fix the problems facing the USA and rest of the world. Its important to remember that it is truly impossible to account for every single factor within the economy, but it is possible to observe data, trends, and correlations between the two.

1. Biological Threat.

COVID-19 has massively affected the production and export of goods from China. If workers cannot work, they cannot produce. If workers cannot produce, then countries cannot export. This is one of the many factors why the China Factory Index has plummeted to an all time low.

In this specific instance the primary problem is supply of goods and services. Not enough workers to produce the products that others rely upon. Shortages lead to price increase. The recent decrease of interest rates promotes spending, but what exactly can be bought? Not very much because supply is the problem, not the demand. Constrained supply and increasing demand is not solved by allowing people to borrow more money. 

2. Market Over-evaluation.

I think almost everyone can agree on one thing: most stock indices were overvalued at recent all time highs. Since the start of 2019, the market peaked at around 37% gain in the 14 months following dating to Feb 2020. Markets have cycles and a tendency to become over/under valued - this acts as the driving force between bull/bear markets.

If we can agree the markets were overvalued, then a pullback was coming. Upon the first major retracement, the Fed pulled the trigger and lowered rates. What was the end goal here? Promote more spending, investing, buy back programs, etc.. to get the market back to over valued status? Doesn't seem like a good solution within the context of an overvalued market. 

3. Positive Feedback Cycle.

The average consumer is not the person who benefits from a rate cut. You don't get cheaper credit card rates, or likely capitalize on mortgage/business loan opportunities. When the rates change it is the corporations which are directly affected. Modern companies love debt in favor of expansion. (Remember the 2008 crisis and subprime mortgage loans?) By decreasing the interest rates, you've made corporations have access to even more debt at a cheaper rate. Debt encourages more debt.

4. Fresh out of ammunition.

We mentioned it earlier, but there are primarily only two ways to stimulate the economy. Print money, or make money more accessible to those who can distribute it to the people via interest rates. The Federal Reserve chose to jump in and intervene very early within the process, and the consequences may be dire. Interest rates can only go so low, and the next meeting on March 17th is likely going to discuss a further decrease in interest rates.

With the funding rate now at 1%, there is not very much room to work with before approaching a flat zero. This anomaly is not something which has ever happened in the United States. However with the current market momentum, it doesn't seem out of the picture.

Want more information?

We've got a free eBook for that! You need to check out our Discord, navigate to #start-here, and download our Modern Finance eBook. It dives in much deeper than we discussed here, and investigates the fundamental factors moving the market. Its jam packed with value, and free!

Fun fact: the Federal Reserve is no more of a 'federal entity' then Federal Express is.

 


Leave a comment