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Could the Fed take us to zero?

Could we go to zero?

President Trump recently tweeted “The Federal Reserve should get our interest rates down to ZERO, or less, and we should then start to refinance our debt. INTEREST COST COULD BE BROUGHT WAY DOWN, while at the same time substantially lengthening the term.” He continued....”The USA should always be paying the lowest rate. No Inflation! It is only the naïveté of Jay Powell and the Federal Reserve that doesn’t allow us to do what other countries are already doing. A once in a lifetime opportunity that we are missing because of “Boneheads.”

The Federal Reserve Committee has historically been removed from political pressure once they are seated. Ironically, President Trump nominated the “Bonehead Chair.” The separation from political influence has obviously gone by the wayside. 

With the level of media coverage on this topic, we felt the need to share our two cents with a focus on how it might impact your plan. 

Spenders benefit from low interest rates

Those with debt (especially substantial debt) would benefit from lower rates. I suppose if we actually got to negative (note the “or lower” comment), we might all benefit. Imagine being paid to take a loan, but don’t get too excited. It is unlikely to happen and if it does, we’ve got bigger issues to deal with.  

Refinancing to a lower interest payment and if possibly extending the term might help in the short term - but you still hold debt (and the US holds a lot of it). Lower rates often push people (and companies) to accept debt they wouldn’t otherwise accept thus raising the total debt load. This is fine until the growth on the project from which you funded with debt returns even less than the low interest rate. This becomes an even greater threat if the loan terms are variable, as many who stretched the limit on home purchases found during the Great Recession. 

Savers suffer from lower rates

If you’re a saver, you will likely suffer from lower rates. A key misconception in his ‘tweet’ is that there is no inflation. The official inflation numbers reveal limited or no inflation. In reality, we find most clients have increasing costs. 

Health care and higher education are two expenses with increasing costs (inflation). These are aren’t always included in inflation measurements. Worse is the fact many can’t delay these expenses. If you plan to help with college costs in the next few years, it is difficult (and financially irresponsible) to hold risky assets. The same can be said for medical expenses or expected retirement living expenses. 

I recognize most readers understand the impact of a change in rates, so let’s move on to why it matters today. 

Different this time

You probably know I struggle with this phrase when it supports an investment sales pitch. But history shows it might be different this time. We have conflicting information with global economies moving in different directions. 

Historically, the Fed lowers interest rates when the economy is struggling. “Cheap money” encourages additional borrowing. The belief is that more people will use loans to fund new projects (or spend) which adds growth to the economy (or company). Rates are usually lowered to offset high unemployment (currently low) or increasing inflation (seems to be a point of debate). Stock valuations are typically falling when the Fed decides to lower rates...or there is an expectation they will fall if not supported. 

But it is different this time. We are not starting with relatively low stock valuations. We continue to trade near valuations only experienced in pre-recession periods. We have close to historic low unemployment numbers. The same people screaming (or tweeting) for lower rates are also claiming we have a strong economy. 

Is it different this time or does someone see a recession coming? If we lower rates can we avoid or at least dampen the effect of a recession? That seems to be the viewpoint from the Fed. 

Are we trying to solve a political problem with monetary policy?

Although the Fed has a dual mandate that is domestically driven, they take global policy into consideration. For example, the Fed delayed raising interest rates prior to the Brexit vote. During her press conference after the meeting, Janet Yellen acknowledged the committee considered the impact of a potential positive Brexit vote. With the benefit of hindsight, Britain voted for Brexit but the impact on the market was short felt (a couple of days). Today, the Fed navigates a slowing global economy and the impact of Chinese tariffs. 

With the benefit of hindsight, we realize the positive Brexit vote didn’t slow our economy. Today’s Fed committee does not have the benefit of hindsight. Fed speakers often cite the ongoing tariff situation as a reason for concern even when we might not be seeing a slowing economy at home. This raises an interesting question. Is the Fed addressing what should be a political problem? The obvious answer is yes. The real answer is...it doesn’t matter. 

A strong economy helps elections

During the Presidential campaign in 1992, James Carville (Bill Clinton campaign strategist) shared the phrase “the economy, stupid.” It was originally meant for internal use as they discussed three key talking points. The other two were…”Change versus more of the same” and “Don’t forget healthcare.” I told you it is rarely different this time!

The point...those seeking reelection (or maintaining party control) like strong economies. Voters tend to put a heavy bias on their current situation when casting their vote. So, it should be no surprise that President Trump prefers lower interest rates if he believes lower rates would spur the economy. This is short-term thinking.  

It’s relative

One problem we see with the idea of lowering rates is the assumption (faulty) that other central banks will idly sit by and let the United States devalue the US dollar versus their home currency. Europe, China and others are matching the Fed’s move to devalue their home currency. If everyone moves down together, the relative advantage is lost. We could argue the Fed has more room to move as they have the highest current yields, but do we really want to be in a race to the bottom?

In his tweet, Trump states… “The US should always be paying the lowest rate.” From one standpoint, this might be true but we might not want to focus on that point. 

If countries were treated as companies, it could be reasonably argued the company with the strongest balance sheet should pay the least to borrow money. It is presumed they have less risk and should therefore pay less to borrow than those with weaker balance sheets. We could argue the US has the strongest economy (again relative). 

Companies borrow money when they feel they can earn more than the interest cost when funding new projects. This sounds simple. If you invest in a new plant that returns 5% when you borrowed at 2%, you win. But the loan still needs to be repaid. 

Consider another scenario. If the same company borrowed the same amount of money but rather than 5% growth the economy slows (falls into a recession) and not only do they not make the expected profit, they don’t have the revenue they had when they first took the loan. 

Arguing for zero interest rates (or lower) assumes the economy (the country’s project) grows. Even at zero, principal needs to be paid. 

Imagine the impact of lowering rates by 2% in one move

The tweet does not say how quickly the Fed should lower rates, just that it should and preferably get them to zero. Imagine what would happen to markets if rates were dropped by 2% overnight. To put things in perspective, consider the Fed’s action to 9/11. The Fed lowered rates by .75% (75 basis points) in hopes of stimulating the market before it reopened. It followed with another .50% decrease shortly thereafter. 

This didn’t keep the market from falling after being closed for almost a week. The markets were already falling as the “Tech Wreck” was unfolding. But that was a different time with different circumstances. Today’s environment includes a decade inflated by cheap money and a “risk on” mentality. A move back to zero would likely extend and amplify the “risk on” viewpoint in the short-term but have long-term consequences that are unknown at this point. 

The biggest question is what if this isn’t the beginning of a recession and we are lowering rates…what would we do if a recession came AFTER rates were at zero?

Return to basics

I try to avoid taking a political stance and this post is not meant as a rant against one person or a particular party. It is a discussion about what I think is a bad idea based on short term considerations without careful consideration of potential long term impact. We get ideas like this from multiple people and varying political affiliations frequently. Today’s political environment seems to be about short-term extremes rather than long-term basics. 

I recommend Steph returns to basics

When Steph struggles with setting, I recommend she returns to the volleyball basics. During the summer club tournament, her coach seemed more interested in foot work (getting to the ball) than hand work (setting the ball). This past weekend, she seemed to struggle. I pointed it out to her (I am her coach and father). She thought she did well because “she got to the ball.” I reminded her that setting is more hands than feet (my opinion). At last night’s practice, she focused on hands first and set much better. 

I find it interesting that whether addressing a parent issue or life concern…in most cases, a quick reminder of basics reveals simple and informed answers. 

How lower rates affect your plan

After years of no yield, we’ve enjoyed collecting higher yields for clients who have upcoming cash needs via preferred money markets and Certificates of Deposit. As interest rates decrease, we lose that option (or at least collect less). Unfortunately, as the Fed lowers rates, short-term saving instruments will follow. 

The reaction to lower yields since 2008 has been to accept additional risk (buy stocks). With stocks near all-time highs, we are not comfortable accepting this risk. Your plan will be impacted more by a significant risk action (market downturn) than a little more return.

We hope the Fed is lowering rates because they believe they can dampen (or avoid) the impact of a looming recession. We say hopefully, because it is arguably worse if we’ve lost the independence of the Fed. 

At the same time we are discussing basics, we are exploring options that don’t fit the normal portfolio because these are not normal times. We are considering ways to protect current stock values. But as you know, insurance is not free. We are reviewing the cost of protection. We’ll share more during reviews and future posts. 

In the meantime, we continue to maintain balanced, diversified and slightly conservative portfolios because if rates fell to zero tomorrow, the market would likely react positively (significantly positive). 

Until next time...