A reactive Federal Reserve has really boxed itself into a corner.
The Fed is known to change tunes as per market capitalization. For instance, the Fed scaled back its rate hike forecasts in December 2018 as markets began pricing a rate pause in 2019.
The Fed then signaled a rate pause in the first quarter of this year, following which markets began pricing in rate cuts and guess what, the central bank removed word “patience” for its forward guidance this week, setting stage for a rate cut later this year.
In fact, money markets are fully priced for a 25 basis point rate cut in July, while few in markets believe the Fed would cut rates by 50 basis points next month. A significant majority out there sees at least 75 basis points rate cuts over the next 6-9 months.
This sounds like a simple and effective strategy… just give the market what it want, so there is no fear of missing or beating expectations and resulting instability or volatility in the financial markets.
After all market are rational right?
I believe markets are always irrational and by merely following the irrational entity, the Fed is now stuck between the rock and a hard place.
As noted earlier, the market has priced in at least 75 basis points of rate cuts for the next 2-3 quarters.
The US stocks are at record highs with the S&P 500 reporting more than 17% gains on a year-to-date basis.
If the Fed doesn’t deliver, equities could tank, leading to financial market instability. On the other hand, if the Fed delivers rate cuts, we could see a sell the fact pullback in stocks.
More importantly, it would further confirm that Fed is more than willing to comply with market expectations and so, with every set of weak Us/global economic data and/or episodes of geopolitical tensions, investors will price in more aggressive easing in turn putting more pressure on the Fed to act.
The self feeding cycle would end up with Fed pushing rates into negative territory.
Hence, I feel the Fed should out its foot down and avoid cutting rates at least till the S&P 500 is holding above the lows near $2,350 seen at the start of the year.
QE and Socialism
Drawing parallels between quantitative easing and socialism is quite easy. In the latter, the state makes sure that every citizen has access to basic needs irrespective of their contributions to the GDP.
With QE, the economy gets cheap money, meaning corporates with low credit rating and the ones with high credit ratting can borrow at same rates. Put simply, QE blurs the line between best performer and worst performers.
No wonder, productivity continues to deteriorate in most advanced nations. These countries run capitalist models but their central banks implement QE, which is socialist at heart.