Here Is Why The Fed's Rate Cuts Won't Have The Desired Effect

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by: Diesel
Summary

The markets have been partying since Tuesday on an anticipation of rate cuts.

The Fed might cut rates, but it probably won't have much effect.

I will explain exactly why that is the case.

On Tuesday, the Fed hinted that it was ready to take action if the US economy started showing signs of weakness. The market cheered and rallied, and we are now only 2% away from all-time highs (as of the time of writing this article). The stock market now expects at least one rate cut, while the bond market is already pricing in 3 rate cuts in the next 12 months.

While it is possible that we will get one or more rate cuts in the future, I don't see these having the desired effect anytime soon. Investors would benefit from moving to or staying in defensive positions and keeping at least some cash on the sidelines while everything plays out and the market catches up to new realities.

Reason 1: Rates are already very low

Currently, the Fed rate stands at 2.25%, and this is already dangerously close to zero, which gives the Fed very little room to go much lower. Just to give an example, during the recession of 2008, the Fed was able to cut rates from 5% to 0% - a drop of 5% - but now there is only room for a cut of 2.25% unless the Fed wants to visit negative rates, which is a whole different territory with different implications, many of which are not positive. Historically speaking, the Fed has cut rates by about 5% in response to each recession, but it doesn't have much room this time.

Reason 2: Debt levels are very high

Normally, the Fed's rate cuts work because they encourage more borrowing. When rates are low, companies borrow more so that they can use that money to fuel more growth by buying more equipment, hiring more people, and upgrading their existing facilities and tools. Companies also take advantage of low rates by refinancing their existing debt. Likewise, consumers are more likely to take on mortgages or car loans when rates are low, which drives further spending. In summary, low rates support more spending by both individuals and companies, which helps the economy grow overall.

Here is the big question: how do you encourage more borrowing when debt levels are already sky high, and does it really benefit the economy when debt levels are dangerously high?

For the purposes of this article, we will break the debt discussion into two categories: consumer debt and corporate debt. Let's look at consumer debt first.

As you can see from the graph below, consumers have been taking on more and more debt since 2011, helped by the Fed's policies that have been in place since the last recession. Now, American consumers are spending 5.7% of their disposable income on debt servicing (interest rates alone). While I wouldn't say this is dangerously high, there isn't much room for growth either.

Similarly, Americans collectively owe $1.2 trillion on car loans, almost double the rate it was back in 2011. Americans are already borrowing and buying cars at record levels, so cutting the overnight rate from 2.25% to 1.50% or even 0% won't encourage more borrowing, and even if it does, it will probably encourage mostly subprime borrowing, since people with good finances are already able to borrow money at attractive rates at the moment.

Below is an interesting chart showing that the average borrowing term for car loans is getting longer and longer. Now the average term for car loans is 68 months, just short of 6 years. There are even car loans being offered with payment plans that go for as long as 8 years. By the time you are done paying off that car, it is already due for replacement. In this environment, it does not make all that sense for the Fed to encourage people to borrow and spend more.

Now let's look at corporate debt. When the Fed launched its zero interest rate program, the goal was to encourage corporations to take on more debt and invest capital into their growth so that more jobs can be created and employment numbers can grow. It was successful to a point, but now corporations are just borrowing money to buy their shares back and inflate their EPS (earnings per share) numbers. As you can see in the chart below, total corporate debt has already doubled in the last 10 years, and corporations are already loaded with debt. It is highly unlikely that they will take on more debt just because the Fed has reduced overnight rates by 0.25-0.50. More importantly, businesses are unlikely to use this newly borrowed capital on hiring and growing their business rather than more stock buybacks.

Rate cuts work best in an environment where debt levels are low and the capital market is tight, because people and companies are too scared to take on debt and banks are too scared to lend money in those environments. We are far from that situation right now. People and companies (not to mention governments) are borrowing very liberally, and banks are happy to lend them money because there is already lots of liquidity in the system thanks to the Fed's ongoing policies since 2009. We don't really have an issue that a rate cut can fix at the moment.

Just to give an example, the Japanese economy has been unable to grow at sufficient rates even after all those generous efforts by their central bank in the past several decades. The European economy is also headed on the same path, and we might be too if we don't get our debt under control.

Reason 3: Valuations are already too high

The Fed's last policy change worked greatly from 2011 and on because valuations of assets were attractive back then. In 2011, the average P/E was around 12-13, the average stock dividend yield was almost 3% and the average real estate price was half of today's. When you have a cheap market with attractive prices, introducing cheap liquidity to the system can certainly increase valuations, but what happens when you do it while valuations are already sky high? Asset prices get pushed to unsustainable levels, and this certainly doesn't benefit our economy, as a lot of people get priced out of owning assets.

Chart Data by YCharts
Chart Data by YCharts

Currently, the median house price in the US is $307k, a value even higher than the top of the 2005 bubble ($250k at the peak). Many Americans are already priced out of buying a home, and reducing the interest rates by another percent or two won't really help them, since it will drive house prices even higher. I certainly hope that banks won't be bringing back subprime mortgage packages in order to encourage more buying at these elevated levels.

Reason 4: Inflation is not that low

The Fed's mandate states that it will help the American economy to sustain a healthy level of inflation. By healthy levels, we usually mean 2% give or take 0.3%. Well, the current inflation rate is already at 2%, so we don't really have much room for growth there either. It is unclear whether the Fed changed its mind about maintaining a 2% inflation rate and decided that a healthy level of inflation is actually closer to 3-4%. If that is the case, the Fed should be more transparent to the public and investors and tell it like it is.

Chart Data by YCharts

Reason 5: The Fed can mostly influence short-term rates

The long-term rates are still determined by the market, and the Fed doesn't have much power there. When banks give people long-term loans to buy houses, cars or appliances, they look at what the overall demand for loans is, and when consumers are shopping around to find the best deal, they are still looking at the lowest rates possible. This is a free market after all, and the forces of supply and demand are still in place. If you look at the chart of 30-year mortgage rates below, you will see that long-term interest rates have already been falling since last December, even without a rate cut from the Fed.

Chart Data by YCharts

Conclusion

In conclusion, just because the Fed's policies worked from 2010 to 2018 doesn't mean they will work the same way again. Now valuations are high, inflation is far from zero, debt levels are already high and interest rates are already at historically low levels. There isn't really much room for the Fed to help the economy any further.

Investors should not get too excited about the rate cut and continue to stay in defensive positions, not to mention keeping some cash on the sidelines. I believe we'll get better buying opportunities in the not-so-distant future.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.