Markets Now Expect Fed to Cut Rates Later This Year
Whenever we see a meaningful drop in stock prices, people start lining up for a rate cut. The recent cuts may have made at least some sense, but one now just does not.
When the news that China had locked down over 50 million people a little over a month ago, as part of a massive effort to contain the COVID-19 coronavirus, the stock market panicked a little bit, as stock markets tend to do with potential threats. There were many who believed that this could cause a correction, a loss of 10% or more in stock prices, but after moving downward for 8 trading days and giving up 4%, we quickly rebounded. 3 trading days later, we recaptured the entire 4%.
While you never can say that a selloff is due to a single factor as there are always other things going on, for instance the competing fears of this virus and the potential economic virus called Bernie Sanders, there hasn’t been any question that round 2 of this has mostly been about coronavirus fears.
Monday’s big decline wasn’t quite as bad as it appeared, with the regular session being more neutral than anything with a lot of back and forth that had us up for the session for most of the day, Tuesday’s drop was of the more ominous kind. The futures market gave us a little head start on the comeback, but with every little tidbit of news on the spread of this virus, the market reeled.
We were told that there is now a single case of this virus in Switzerland on Tuesday, and even something as meaningless as this served to panic the market. We may wonder why anyone would even care about such a thing, but this did serve to show us just how irrational things have now become.
Things looked brighter on Wednesday, and in the early part of the session, the Dow was up over 400 points. Then we heard that U.S. authorities were preparing for a “pandemic,” and this news completely bypassed our critical faculties and headed right to the part of our brains that get scared and run, or at least the part of those big computers that do most of the trading in the stock market.
We now have our correction, and we’re off by 10% now from the high we were at 8 trading days ago. Both round 1 and round 2 have lasted this long, but when the most trivial of things take us from a big up day to a big down day, you know panic has set in for sure.
A lot of this is to be blamed on sell programs, and when you see news that really shouldn’t affect things portending so much, even the human brain with all its faults and it’s disposition to doing stupid things when it is afraid can’t compete with the fear that computers feel, taking meaningless data or observations and using it to drive markets down well in excess of what would make sense, because they are programmed to do it.
Sell programs are very powerful, although their sheer power is usually contained by arbitrage, where if we get too far ahead of ourselves on the down side, this will stimulate demand from those who think we’ve gone below “fair value” and will jump in to buy at these lower prices.
Monday and Tuesday didn’t have us seeing much of this, and on Tuesday, the buyers simply stood down and the sellers had their way without a lot of opposition. The way that Wednesday’s rally was simply crushed on the word that U.S. health authorities are preparing for the worst, even though the number of people in the U.S. affected by this remains a completely meaningless number, is what was so troubling about Wednesday.
We would hope that we are prepared for a real pandemic if one ever does come, but to think that we’re facing one right now is simply ludicrous. After a month of this all going on, there are only 60 people in the country who have this virus, all of whom contracted the virus elsewhere and have since returned home.
This isn’t even a threat well contained, it’s not even a threat yet at all yet. The whole incident wasn’t much of a threat in the first place, but it turns out that there is so much paranoia out there about pandemics that you can take a little story like this and blow it up to epic proportions, like we are doing with this virus.
One month in, we’ve broken the 80,000 mark with cases worldwide, and the death toll has now surpassed 2,700. This may sound bad when you look at this in isolation, but to provide a little perspective, 80,000 people died in the United States alone from the influenza outbreak during the winter of 2018.
The stock market didn’t even notice this though, and the reason was that the media had not chosen to hype it, perhaps because people just don’t fear influenza all that much due to it being so commonplace. Novel viruses though, the sort that they make movies about, are a different story altogether.
When we put these two things side by side, an actual epidemic that took the lives of 80,000 Americans versus 60 people quarantined from a virus they caught elsewhere, if the fear involved with this handful of cases is supposed to be a big deal in comparison, or any deal at all, something is dreadfully wrong with the way we think.
Risk Involves Both Fear and Probability, But All we Have Now is the Fear
Those who are shaken by these events will tell us that this is all about risk, but how we get from a handful of people that are being kept well away from the general population to a nationwide pandemic of any note does not appear to be even thought through. We are like Pavlov’s dog, when we hear the bell and cower, and the media is indeed our Pavlov.
A lot of people do not exactly take a rational approach to fear though, and given that fear itself can be such a powerful suppressor of reason, none of this is all that surprising, although the stock market selling off this much from such things as authorities being prepared for the worst without any sign of the worst or even anything at all of real note surfacing might even set the standard for nationwide paranoia.
Unfortunately, you can’t just take the stock market by the shoulders and give them a good shake, because this is just not how it is programmed. It will take the media blowing this out of proportion so much at face value, and each bad story that comes in adds to the cumulative effect of this panic.
Ironically, this virus is well under control now, with new incidents being on the decline for some time now and it growing in China so slowly now that the new infections in other countries have surpassed it. If you were a copywriter looking to give the people what they seem to want, the maximum scare that is, you could frame this as the incidents in other countries exploding to overtake China, even though the real story is that China has finally contained it.
With the fear side now being so empowered, there’s no telling how deep this may take us. We’ve only given back this much or more on one other occasion since the financial crisis, in 2018, and while that one was twice as big, the sheer speed and the sheer lack of sensibility with this one has us wondering when it will end and whether it may become a contender for the biggest sell-off in over a decade.
At some point though, the buyers will likely take over, and that appeared to be the case in the first couple of hours Wednesday until we once again were sent reeling from news that should have been completely trivial. Considering that there’s only so much downside that even can be imagined from this, and the fact that we have already overreacted to this so much already, it’s hard to imagine our paying much more of a price for this concocted nightmare.
There will be some economic consequences of this, not from the virus itself but from all the restrictions that it has caused, but there isn’t anything to even suggest that this will be all that noteworthy. The market already came to this conclusion, and this latest move hasn’t been about that at all, it has simply been about paranoia of a global pandemic. There’s no reason to think that, but when it comes to paranoia, we usually don’t need one, as our imaginations running wild will do just fine.
We’re now hearing that the “market” has priced in further rate cuts by the Fed in 2020, and perhaps more than one. Some are arguing that rate cuts won’t really do much for this, even though we will probably see some more, but we want to take this one step further and tell them to not be so sure that we will get some just from this.
Some look at how bonds are rallying from this latest so-called crisis and think that this in itself portends a rate cut or two. It does not make sense to jump to conclusions like this though, because while the two may be correlated, for them to be, there has to be independent evidence at work that both causes bonds to go up and the Fed to cut.
If anything, bonds rallying makes it less necessary for another cut, as these things lower the price of credit not only with treasuries but with corporate bonds as well. Not only is this not a concern in itself for the Fed, it’s actually one of their targets, and if bonds don’t go up the rate cut didn’t work that well.
You can place a bet on pretty much anything financial related, including betting on whether the Fed will cut and when, and not surprisingly, a lot more bets are being placed on a cut then before this second wave of virus fear hit.
Many think that this sort of thing somehow actually makes these cuts more likely, even though none of this has any bearing whatsoever on what the Fed may actually do, and they will be basing their decision on what’s happening in the real world, not on how these side bets are going.
There just isn’t an expectation right now that the impact that the coronavirus will have upon the economy will be even meaningful enough to warrant a cut, although there is another side to this that we need to appreciate, one of relevance.
We need to think of the U.S. economy as an engine, and one that is running pretty much full bore right now. What rate cuts do is seek to turn up the speed of the engine, which involves mostly the supply side. When this engine runs a little slow, the Fed will try to prime it as it did last summer, to get it producing more.
Lowering rates will have U.S. companies borrowing more, which in turn stimulates production, and this can be a very useful tactic in some circumstances. The coronavirus is not one of them though, as the issue here is outside the scope of U.S. action, involving both reductions in supply and demand in China.
Lowering the Fed rate all the way to zero again just isn’t going to make any difference in China, and while the Chinese government is working furiously with their own monetary policy to get things back up again, our monetary policy just doesn’t matter to this.
Rate Cuts Are Not a Free Good and the Cost Needs to be Justified
Whenever we make moves to expand the economy through rate cuts, there will be a price to be paid down the road, so we want to be careful to make sure we actually get enough of a benefit. These bullets need to be targeted, where there is a present need of sufficient magnitude to justify the cuts, rather than just shooting the gun off in the air as we would do to scare something away.
Each time we cut, we expand the amount of corporate debt out there, who will invest the money at various rates depending on the need. If they don’t need it to expand, or if they only need a part of it, they will still borrow and spend it, even if that just means buying more of its stock.
These things certainly can help stocks, but monetary policy never can be about stocks, it has to address the economy, which is fueled by actual investing and not companies just taking equity off of the table.
The two issues with the coronavirus are how it has affected the supply chain in China as well as how it has reduced Chinese demand. There isn’t a thing that U.S businesses or the Federal Reserve can do to help this along though, so this would be a bullet that would be wasted on the economy, even though the stock market may benefit. The stock market only consists of bets on things, including bets on the economy, and the Fed needs to worry about the real world.
A cut or cuts won’t improve this, or even stand to improve the U.S. economy in a meaningful way either, because it is already at full capacity. If this starts to drop off too much, we can at least have a look at doing this, but not before such a thing happens as otherwise there isn’t enough potential for benefits to accrue.
When you add in the fact that the problem isn’t a lack of capacity, as we’d be happy to satisfy the Chinese market to their heart’s content once they get well again, which isn’t that far off, being able to make even more right now just isn’t going to help, even if we could.
It also would not help companies who rely on production in China, either directly or indirectly, as whatever the U.S. funds rate is, this has nothing to do with getting them back to work over there.
That’s all pretty clear, but the argument will be that if we do see a downtick in the economy from all this, which we will, we need a stimulus to get us back to where we were. This really depends on the source of the problem though. If the problem is with the U.S. economy itself, and we stimulate it, this can certainly help. If the issue is with the Chinese economy, there’s nothing to do but wait for it to pass.
It is not that there won’t be a meaningful impact on many U.S. companies, but the overall effect on the economy is expected to be quite minor, and certainly temporary. We should actually expect to be in a better place once the dust settles from this, by way of the potential for more lasting effects from China’s efforts to stimulate their economy, at least in the near term anyway, although ultimately there is always some price to be paid for economic expansionism.
We can only hope that the Fed uses good judgement and does not cut rates this year unless there is a valid reason to do so, and they surely will understand the basics that we are presenting to you here enough to wish to show restraint. Cutting rates under full employment isn’t all that sensible in the first place, but is especially not so much when the issues that it seeks to remedy aren’t even under our purview.
The biggest reason for restraint is the temporary nature of this shock, and we do not want to be left in a position where we have to put rates back up to reach equilibrium again. The key to our economic stability is the fact that we’re not growing at an unsustainable rate, but once this does happen, this is when the pain will come.
Donald Trump or the average person on the street does not understand all this very well, and this especially applies to people who own stocks that just want to see the Fed become even more dovish. They do not get that doing too much of this ends up hurting their stock positions as well as the economy more than it may help, especially if these cuts are made without due consideration.
People love to worry it seems, and they are not only worrying about the country getting locked down because we have 60 people quarantined for what amounts to be a fairly tame virus as far as they go, and only affecting a minute percentage of the population, they also worry when bonds rally, and they have been doing plenty of rallying lately. The computer programs that rule the roost in the stock market on a day-to-day basis also aren’t fond of bond rallies, and are programmed to sell when this happens, adding to this whole mess.
Whenever we see a sell-off based upon news, we really do need to take a step back and wonder how much of this is an overreaction. This current selloff may even set the standard for this, and as capricious and fearful as stock markets can be at times, this may have set a new low.
Wondering about rate cuts is really limited to entertainment purposes only, as the Fed will do what it sees fit regardless of what the people want or believe, but we have quite an appetite for entertainment, especially with being so entertained by contemplating dire scenarios such as pandemics. Computers get entertained by this as well it seems, and have the power to really break up stock parties as we are seeing.
Thursday looks like it will be another down day based upon how the off-hours futures betting is running, but at some point, we’ll have had enough of this nonsense and look to make some sort of recovery. This coronavirus situation is one that will have an economic impact, but not one that is even close to what the market has priced in. Once we see this enough, once the humans take control again, things should return to normal more.
Editor, MarketReview.com
Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.
Contact Monica: monica@marketreview.com
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