"You don't go long the first rate cut, you go long on the last one."
-- David Rosenberg, Gluskin Sheff
Market participants have responded positively to Fed Chairman Powell's more dovish utterings since December - The Powell Pivot II!
Despite trade disputes on increasing fronts and more signs of weakening economic growth (global manufacturing PMI is at a seven-year low and the three-year U.S. counterpart is at a three-year low with backlogs and vendor performance weak) that euphoria has been even more celebrated in the last two trading days.
Back in November 2018, in my 15 Surprises for 2019, I predicted that the Fed would pause this year and would cut rates in the third quarter of 2019, leading to more quantitative easing in 2020.
This Surprise seems likely as the current 50 basis point (plus) inversion between the fed funds rate and the two-year Treasury note always has led to rate cuts over time.
Though the market's expectations (in only six or seven months) has moved from three rate hikes to three rate reductions, to this observer the market and economic enthusiasm are unjustified for the following reasons:
1. Interest rates already start from a near historic low.
2. Lower interest rates won't solve the problem of a massive U.S. debt burden.
3. The economic expansion is now long in the tooth, celebrating its 10th anniversary this month. The last similarly long expansion (believed to have been a "new paradigm," ended abruptly as a result of the lagged impact of tightening.
4. While large debt loads will be aided by lower short-term credit costs (by lowering debt service), many companies (and municipalities) have already refinanced.
5. The headwind facing the housing market is not low mortgage rates -- it is lack of affordability and changing demographic trends.
6. Lower interest rates (from here) adversely impact the engine of credit creation -- commercial banks. With lower interest rates, deposit growth has slowed -- that's the lifeblood to a healthy banking industry. Banks, even in the face of fed fund cuts, will be even slower that usual to pass on lower lending rates (credit cards, mortgages, etc.).
7. Market rates have already captured the expectation of more fed fund cuts. It is quite possible that even three fed fund rate reductions will result in an increase in long bond rates.
8. Taking into account the nine Fed tightenings and QT, rates have been raised by nearly 350 basis points in this cycle. Over history, such a tightening has invariably produced a recession with a six to 18-month lag.
9. Credit quality is weakening. According to Moody's, covenant protection on loans and bonds is the poorest in history. This will not change with lower interest rates.
10. Historically, stocks have performed poorly into the early stages of a cutting cycle.
11. The lack of coordination between G8 countries is unprecedented -- and despite fed funds rate cuts more trade rifts may raise inflation and inflationary expectations. Trade conflicts create a roadblock of uncertainty, impeding consumer and business sentiment and spending (regardless of the trend of interest rates). A reversal of globalization (coupled with adverse demographic trends) support a secular slowing in global economic growth.
12. The lack of fiscal discipline (by both Republicans and Democrats) is unparalleled. There is a national debt time bomb that is gaining in potency daily.
13. Rising geopolitical risks (notably in North Korea and Iran) are also unique to this cycle.
14. The animus between the parties will delay a much needed infrastructure program or any other fiscal stimulation, for that matter. Again, unique in this cycle.
15. Disruptive technology's role in lowering prices and knee capping industries will be unaffected by lower interest rates.
16. Brexit, unique in the face of a rate-cutting cycle, may not be smooth (and will likely be disruptive and economic growth unfriendly).
Governor Eccles: "Under present circumstances there is very little, if anything, that can be done."
Congressman T. Alan Goldsborough: "You mean you cannot push a string."
Governor Eccles: "That is a good way to put it, one cannot push a string. We are in the depths of a depression and..., beyond creating an easy money situation through reduction of discount rates and through the creation of excess reserves, there is very little, if anything that the reserve organization can do toward bringing about recovery."
-- House Committee on Banking and Currency (in 1935)
Pushing on a string is a metaphor for the limits of monetary policy and the impotence of central banks.
Monetary policy sometimes only works in one direction because businesses and household cannot be forced to spend if they do not want to. Increasing the monetary base and banks' reserves will not stimulate an economy if banks think it is too risky to lend and the private sector wants to save more because of economic uncertainty.
This cycle is much different than previous cycles as there are a host of anomalous conditions that will work against the likely rate cuts that lie ahead.
What has occurred in the last decade?
- $4 trillion of QE
- $4 trillion of corporate debt piled up
- $4 trillion of corporate buybacks
- A Potemkin-like expansion in earnings per share as the share count drops to a two decade low.
Meanwhile, capital spending has failed to revive (leading to negative productivity growth).
And, as a three-decade low in birth rates and fertility are combined with restrictive immigration policies around the world, labor force growth has dropped to about only 0.5%/year -- and with it has been accompanied by a secular reduction in the prospects for global GDP .
While this is not a short-term call for an imminent drop in the equity market, if my concerns are prescient and fully realized we will likely see more than the process of a market making a broad and important top.
Rather, we will probably see a sustained Bear Market.
The Fed is pushing on a string.
(This commentary originally appeared on Real Money Pro on June 6. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns from Paul Price, Bret Jensen and others.)