The Federal Reserve has a math problem, and so do investing markets.
Everyone from the president on down is demanding interest-rate cuts, lots of them. Fed Chairman Jerome Powell called the July rate cut a “mid-cycle” adjustment, and it has bought the Fed precious little as markets sold off in the wake off more trade tensions and yields continued to plummet. And now the markets are demanding more — a lot more. A 50-basis-point cut to the federal funds rate appears to be the bare minimum investors are demanding for September. Call it pricing it in, and the implication is clear: The Fed can ill afford to disappoint.
And what markets are currently pricing in is anything but a “mid-cycle” adjustment:
That is nearly a 100-basis-point rate cut over the next year. President Trump, of course, wants that large a cut now and some quantitative easing sprinkled on top of that:
Leaving aside a discussion about the economic wisdom of such demands, let’s look at the implications of Trump’s wishes, and on a longer time frame, the market’s demand for 100 basis points of rate cuts.
The problem is the Fed has very limited ammunition compared with previous cycles, and that fact seems to escape everyone.
Between December 2015 and December 2018, the Fed raised rates nine times after keeping the federal fund’s target range between zero and 25 basis points since Dec. 16, 2008 — the weakest rate-hiking cycle ever. In 2018 expectations were still high for further rate increases in 2019. In fact, Goldman Sachs had projected five rate increases for 2019 as late as November 2018.
Those days are long gone as global yields have collapsed and economic data has continued to show significant slowing. Hence the rate cut in July:
And therein lies the math problem. With one rate cut already under its belt, the Fed now only has eight rate cuts to work with before being right back to zero-bound.
Cutting by 50 basis points in September would leave the Fed with only six 25-basis-point rate cuts to play with. Cutting another 50 basis points over the next year would leave the Fed with only four 25-basis-point rate cuts, implying the Fed would have given back nearly half of its entire rate-raising cycle, which took three years to accomplish, in only 12 months. That wouldn’t be a “mid-cycle” adjustment.
For reference: In 2001, the Fed had to embark on a rate-cutting cycle of 550 basis points to stop the unfolding recession. In 2007 it took 500 basis points. This time the Fed has started its rate-cutting cycle from a 225-250 basis-point basis. When cycles turn in earnest, they get angry and demand a lot of Fed hand holding.
So I must ask: With such limited ammunition to work with and so much ammunition required to actually stop a cycle turn, why would the Fed waste more rate cuts with markets still near all-time highs and unemployment still at 50-year lows? Why risk a 50-basis-point cut and be left with only six 25-point cuts in the coffer? Recession risk, after all, is rising and even Pimco is acknowledging this. Unless the ultimate future is rates into the negative 200-250 basis-point territory, which would imply a full-out disastrous crisis, then perhaps markets are expecting way too much from Momma Fed at this stage.
And if this is the case, then markets may be setting themselves up for disappointment. The first test of this thesis will come on Friday during Powell’s Jackson Hole speech. Markets are eagerly awaiting a signal to confirm more aggressive rate cuts. The Fed has a math problem and a market beast that wants to be fed. By the Fed.
Powell can ill afford to disappoint. But there may be another problem lurking. If the Fed is too aggressive, feeling beholden to markets, it may inadvertently send a signal that the recession risk is real and markets may ultimately not like the sound of that.
Sven Henrich is founder and the lead market strategist of NorthmanTrader.com. He’s well-known for his technical, directional and macro analysis of global equity markets. Follow him on Twitter at @NorthmanTrader.