Central Bank, The Futile Interventionist

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by: TickerSquare
Summary

Central bank switched from tightening to easing policy late 2018 to early 2019 culminating in a 25 basis point rate cut in July.

The market welcomed the news during the first half of the year.

Rate cuts at this point in economic cycle are far less effective at best and completely useless or even harmful at worst.

In the first half of 2019, the stock market was on a tear. Between Jan. 1, 2019 and July 1, 2019, S&P 500 rose 18%, Nasdaq Composite rose 20%, and Dow Jones Industrial Average rose 14%. This was in good part due to the revelation that central bank shifted policy towards monetary easing. While the actual rate cut was met with disdain, perhaps because it didn't reach expectation levels, the prevailing reaction to the idea of monetary easing has been positive. Not everyone is on the same page, however. Numerous pundits have chimed in that rate cuts at this juncture are unwise and counterproductive.

A great many of these experts raise issue with the possibility that cutting rates now may reduce or eliminate one of the few weapons central bank has at its disposal to combat an actual slowdown. Yet others point to the fact that cutting interest rates is ineffective in preventing an economic downturn. It is this last point that piqued our interest. Monetary easing certainly seemed superbly effective in buoying the economy out of the Great Recession, why wouldn't it help now?

Well, there appear to be multiple reasons. One is explained eloquently in this article: Why Rate Cuts Don't Help Much Anymore.

If you don't want to read the entire article, here is the gist as it relates to rate cut (in)effectiveness.

The worry, arising from some important new research, is that the benefits of Fed rate cuts in today's environment may be substantially overrated.

Typically, when rates drop, consumers buy more durable goods like washing machines and cars, homeowners refinance their mortgages and effectively get a tax cut, and businesses invest more because the cost of borrowing goes down. But lower rates may have much less impact on these behaviors now. In the language of economics, the economy is suffering from a "weakened monetary transmission mechanism."

So, interest rates are less effective now in spurring spending, which is a major force behind GDP growth.

But what about labor as the most direct driver of GDP?

A little reflection reveals some clues about diminishing influence of rates on labor at peak economy. We'll call this the capacity for economic expansion. If GDP can be likened to water, recession is like an empty glass able to hold increasing amounts of water. The cycle peak, on the other hand, is like a glass already full of water. Adding water would not change anything.

GDP is directly proportional to labor size and labor productivity. At the peak of an economic cycle, unemployment is low. The limiting factor in labor size becomes availability of workers instead of availability of work. Interest rates can only help bolster available jobs, not workers.

Labor productivity also reaches its limits as cycle peaks. By the time economic peak arrives, companies are flush with cash. They don't need financial incentives to streamline their processes. Any productivity improvement that makes financial sense would have already been implemented.

Consequently, labor size and productivity exert limits on GDP growth as economy peaks irrespective of monetary policy.

This effect is in full display in the following chart.

The graph shows close correlation between falling unemployment rate and economic downturns. Granted, there is a wide range of unemployment bottoms; from 2.5% in the 1950s to 7.5% in the 1980s. But labor is not the only driver for economic movement, and "Full Employment" varies considerably during different periods as expressed in the following excerpt from Wikipedia.

For the United States, economist William T. Dickens found that full-employment unemployment rate varied a lot over time but equaled about 5.5 percent of the civilian labor force during the 2000s.

In effect, when the economy runs out of workers and labor productivity peaks, GDP can only change in one direction. It can stay constant or move down. Staying constant is like walking a tightrope. Eventually, the balance is tipped off, and the economy begins to tank.

What About the Dreaded Flattening of the Yield Curve?

Everyone seems to be preoccupied with the yield curve nowadays. So, anything that reverses its flattening is bound to postpone a downturn, right? Well, not necessarily, but first, let's examine the effect rate cuts have on the yield curve.

It only makes sense that, under normal circumstances, any rate cut would lead to a steeper yield curve. After all, shorter-term yields are more sensitive to interest rate changes.

The following chart shows how the 2-year Treasury yield follows the Fed Rate much more closely than the 10-year Treasury yield.

The following graph shows the actual yield curve between the 10-year and 2-year Treasurys vs. the Federal Funds Rate. It is very clear that they move opposite to each other most of the time (that wasn't the case after the most recent rate cut).

The flattening of the yield curve in the months and years before a recession is an indication (symptom) and not the cause. Rate cuts at the cycle peak may alter this particular symptom, but it is not clear at all if the effect translates into the cause as well. If anything, artificial interference with the naturally occurring signs and symptoms may lead to decreased awareness of impending trouble.

This leads us to the idea of economic cycles as a natural phenomenon. People have come a long way in appreciating that interference in the natural order of the physical world can lead to unintended consequences beyond our understanding. Perhaps, this attitude will someday translate into financial systems as well, and those who are empowered with altering the natural course of events will think twice before making a move that is not absolutely necessary.

In closing, the next time you feel like celebrating the news of a rate cut, remember, as with everything else in the stock market, timing is everything. What was good for the economy at the depths of the great recession may actually be bad now.

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.

Additional disclosure: The author is not a financial adviser. The information contained in this article is not guaranteed to be accurate or reliable. The information provided is informational only and should not be construed as a recommendation to buy or sell certain instruments (equities, derivatives, etc.), or to enter into any other kind of financial transaction. Please do not rely on this information as the basis for any financial decision. All financial transactions including investments contain risks and can lead to significant losses.