Submitted by Taps Coogan on the 27th of June 2019 to The Sounding Line

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Wolf Richter, creator of the website Wolfstreet.com, recently discussed how market conditions and the Fed’s dovish communications have succeeded in pushing down long term interest rates to a greater extent than the Fed has been able to achieve in the past with multiple rate cuts and trillions of dollars of QE.

Some excerpts from Wolf Richter:

“The Fed has already been able to accomplish more with its verbiage this year than it had in the past when it actually cut rates multiple times, all the way down to near-zero and did trillions of dollars of QE.”

“The way the Fed tries to stimulate the economy is to loosen up credit, meaning it wants to encourage banks and other entities to lend and encourage or force investors to invest more by taking larger risks for less return as they begin to chase yield… But when the Fed cuts its target rate for the Federal Funds rate, it only moves an overnight rate that consumers and business don’t have access too. So, (the Fed) hopes that short term credit market rates… will follow the Federal Funds rates and they usually do. But, short term rates only have limited impact as a stimulus. The transmission channel for the short term rates to the real economy is loans that are pegged to LIBOR… But most lending is done over longer terms with fixed rates such as mortgages, bonds, and the like, and those rates are much more impacted by the 10-year treasury yield. So, what the Fed really wants to accomplish by cutting rates is to encourage market participants to bid up long term bonds and thereby push down long-term yields. The benchmark for this is the 10-year treasury yield…”

“October 2008, when the Fed’s target was down to 1%, the 10-year yield was still around 4%. In other words, after cutting rates for an entire year, and cutting by over 4% on the short end, the long-term yields had come down by only 1%. In late 2008, as Lehman imploded and the US financial system was on the brink, the Fed cut its target rate to near zero percent and briefly, with markets in a panic, the 10 year yield dropped from 4% to a low of 2.8%, about the same as today. But then it snapped back and just a few months later in June 2009 the 10-year yield was back in the 3.5% to 4% range and it took the Fed years and trillions of dollars of QE… to bring long term yields down… (Today) just by the market’s interpretation and imagination, the 10-year yield is now 2.08%. This is lower than it was for most of the time when the Fed’s target range was near zero percent and when it was buying trillions of dollars of securities under QE specifically to get long term rates down. Now the Fed is doing neither… This has a very stimulative effect on the economy….”

“The Fed hasn’t even cut and it has already accomplished everything it could ever want to accomplish to stimulate the economy… Which poses a question: why would the Fed cut rates and what would rate cuts actually accomplish at this point?”

The market is seemingly convinced of two things: a slowdown is coming and the Fed will deliver stimulus. Accordingly, the market is front-running both and pushing long term rates down to levels consistent with massive stimulus during a deep recession. Similarly, the stock market is near all-time highs.

The question that Wolf Richter poses highlights the circular logic of today’s market. If the market prices-in stimulus before it arrives, the need for that stimulus is actually reduced. If the Fed then doesn’t deliver the stimulus because the economy isn’t as weak as feared, is that bad news for markets?

Perhaps the key is not whether the Fed actually cuts rates but that the market truly and completely believes that the Fed will aggressively cut rates if there is a slowdown. If the market truly believes that, as it appears to, then virtually all outcomes are eventually good outcomes for the market. Either things get worse and the Fed delivers an avalanche of stimulus or the Fed doesn’t need to. In other words, central banks are promising markets a bailout. It’s a horrible idea, unless of course your are an investor.

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