It’s not so stealthy.
This is the transcript from my podcast, THE
WOLF STREET REPORT:
Let me just throw this out there for us to kick around: The Fed has
already accomplished more with its verbiage so far 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. We’re already seeing the first
results. Here’s why.
The US government can directly stimulate the economy by borrowing
trillions and spending them in the US on infrastructure, on its employees,
armaments, etc. The Fed cannot do this. It can only try to manipulate the
credit environment in a credit-based economy.
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. The hope is that this will result in easy
access to borrowed money for businesses and consumers, that they can borrow
cheaply, and that they will go out and spend and invest this money. This spending
and investment stimulate the economy.
But when the Fed cuts its target range for the federal funds rate, its
only moves an overnight rate that consumers and businesses don’t have access
to. So it hopes that short-term credit market rates, such as the one-month
Treasury yield and the three-month Treasury yield or various LIBOR rates will
follow the federal funds rate. And they usually do.
But short-term rates have only limited impact as a stimulus. The
transmission channel for these short-term rates to the real economy are loans
that are pegged to LIBOR, for example, and those loans will be become
cheaper.
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.
If you want to stimulate housing, you need to bring down mortgage rates,
and the interest rate of the most common mortgage in the US, the 30-year
fixed-rate mortgage, tracks the 10-year yield.
And if you want to stimulate business investing and business spending, you
need to bring down corporate bond yields, from top investment grade bonds all
the way down to the riskiest junk bonds.
And if you want to stimulate business investing and business spending, and
consumer spending, you can boost the stock market and the IPO market.
Companies with high stock valuations have more financial options and can
borrow more easily.
For example, Tesla: it has a mega-stock price despite billions in losses,
and investors keep giving it more and more money when it needs it. So Tesla
sells more bonds and more stocks, and then takes this money and burns it.
This act of burning investor cash in a money-losing operation means that
Tesla spends or invests all this investor money, and this is a stimulus for
the economy. If Tesla could no longer borrow and could no longer sell new
shares to raise more funds, it could no longer spend and invest all this
money, and it could therefore no longer stimulate the economy with this
money.
And this happens over and over again across the corporate sector.
High asset prices – such as record inflated stock market valuations – also
are said to cause the Wealth Effect to where those that benefit from the high
asset prices, including homeowners, bondholders, and stockholders, are now
feeling flush and more secure, and so they’re spending a little more. They
might finally replace the roof, or put solar panels on it, or repave the
driveway, and they might redo the kitchen, or buy more clothes or that
$90,000 4×4 crewcab, all of which stimulate the economy.
These are part of the “transmission channels” of monetary policy…. the
channels by which the Fed hopes its rate cuts will simulate investment and
spending.
So, the last time the Fed cut rates, it started in September 2007. The Fed
cut 50 basis points, from 5.25% to 4.75%, and then it cut, cut, cut as the
economy and the financial system was spiraling down, and by the end of 2008,
its target rate was near zero %.
So when was all this rate cutting at the short end transmitted to long
term rates and the real economy? Let’s see.
By October 2008, when the Fed’s target rate 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 percentage points on the short end, the long-term
yields had come down only about 1 percentage point.
In late 2008, as Lehman imploded and as the US financial system was on the
brink, the Fed cut its target to near zero percent. And briefly, with markets
in a panic, the 10-year yield dropped from 4% to a low of 2.08% about the same
as today. But then it snapped back, and just a few months later, by June
2009, the 10-year yield was back in the 3.5% to 4% range – despite the Fed’s
near-zero rate and QE, where it actually bought Treasury securities and
mortgage-backed securities.
And it took the Fed years and trillions more of QE to bring long-term
yields down, but it had trouble keeping them down because, after they’d
finally dropped, they’d suddenly surge again.
So where are we today?
The Fed’s target range for the federal funds rate is between 2.25% and
2.5%. The effective federal funds rate is right in the middle of that target
range, at 2.37%.
Short-term Treasury yields have plunged, pricing in with near-certainty a
rate cut in July, and more later in the year. The three-month dollar LIBOR
has dropped in parallel to 2.4% from 2.8% at the end of last year.
The Fed still hasn’t cut rates, but already via the dropping Libor, the
floating-rate loans are getting cheaper.
OK, the real action is with the 10-year yield. By last October and early
November, it had risen to 3.2%. And it had driven the average 30-year fixed
rate mortgage rate above 5%. And it caused corporate borrowing costs to surge
as well.
But just by the market’s interpretation and imagination, the 10-year yield
has now dropped to 2.08%.
This is lower than it was for most of the time when the Fed’s rate target
was near 0%, 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 – in fact, it’s still unwinding QE and
shedding securities. And yet, the 10-year yield has dropped this low.
This has a very stimulative effect on the economy. Mortgage rates have
plunged, and home buying has picked up, though it remains lower than last
year at this time. Home prices which had been dropping in some of the most
overpriced markets have stabilized in some markets and are rising in others.
Consumer spending has picked up in recent months.
Financial services, the largest sector in the US economy, are growing at a
hot pace. Most other services are growing at a good pace.
Business investment is weak, it has gotten hit hard by investment in the
huge US oil-and-gas sector that has dropped sharply due to the plunge in oil
prices since last fall. This impacts in a big way manufacturing and other
sectors that supply the oil-and-gas business. But investment in oil-and-gas
depends much more on the prices of oil and gas than on interest rates.
Stock prices are at all time highs. So the “Wealth Effect” is active,
stockholders feel flush and they’re spending.
Corporate investment-grade bond yields have plunged in parallel with the
10-year Treasury yield. The average AA-yield is about 2.7%. Junk bond yields
have come down too. All this is very stimulative. Credit is easy to get and
cheap, and companies are borrowing, and so are consumers.
Last time the Fed cut rates, and instituted QE, it took years to get these
long-term yields this low, and achieve that kind of economic stimulus. There
was a lot of discussion about the transmission channels back then, about the
lag between cutting short-term rates and when long-term rates would finally
come down, and when this would finally impact the real economy.
But now, the Fed hasn’t even cut, and it has already accomplished
everything it could ever want to accomplish to stimulate the economy. And the
economy is starting to show it. In other words, the Fed is already
stimulating the economy more with its verbiage so far this year than it was
able to do in the past by actually cutting rates multiple times and doing
trillions of dollars of QE.
Which poses a question: As these low market rates are stimulating the
economy and boosting economic growth, why would the Fed actually cut rates?
And what would rate cuts accomplish at this point? I don’t know either. It
just doesn’t make sense. And the Fed might just be kind of patient to see
where this is going, while patting itself on the back for having accomplished
all this just by deploying its verbiage. You can listen to and subscribe
to my podcast on YouTube.
Enjoy reading WOLF STREET and want to support it? Using ad
blockers – I totally get why – but want to support the site? You can donate
“beer money.” I appreciate it immensely. Click on the beer mug to find out
how:
Would you like to be notified via email when WOLF STREET publishes
a new article? Sign up here.
