Only a Half-Point Rate Cut From the Fed Will Do
(Bloomberg Opinion) -- Federal Reserve Chairman Jerome Powell was right in making clear during his Congressional testimony last week that despite the strong jobs report for June, the central bank will cut interest rates for the first time since 2008 at its monetary policy meeting later this month. He was wrong in dismissing the need to reduce rates by half a percentage point.
By lowering its target for the federal funds rate by just a quarter point, the Fed risks no less than a recession. The Fed has a history of moving too slow to respond to evidence of weaker growth, and a bold move now would help ensure the economy achieves the rare “soft landing.”
To make the case for a 50-basis-point rate cut, let’s start with the economic factor that best correlates with the move in bond yields: forecasts for growth global gross domestic product growth. This chart compares 10-year U.S. Treasury yields to economists’ estimates of 2019 world GDP growth based on survey data compiled by Bloomberg. They closely follow each other.
It’s true that most of the slowing in world growth is coming from outside the U.S., which helps explain why bond yields in many sovereign debt markets are substantially lower than in the U.S., and even below zero in some cases. The global stockpile of negative yielding debt has more than doubled since October, reaching more than $13 trillion last week.
These ultra-low yields contrasts with the current target for the federal funds rate of 2.25% to 2.50%, which is out of line with everything else in a manner that is unprecedented. Consider that in 2015, 60% of sovereign yields worldwide were higher than the fed funds midpoint of 0.125% at the time. Now only 6.8% of sovereign yields are higher than the current midpoint of 2.375%. That number drops to just 1.2% if yields on U.S. Treasuries with maturities greater than 10 years are excluded. Unless U.S. inflation and growth are a clear outlier, which they are not, the funds rate should not be an outlier.
The inverted yield curve is sending the same message that the fed funds rate is too high. Many think that when short-term yields rise above long-term yields it signals an oncoming recession. In reality, it means that the cost of obtaining credit (interest rates) is too high and if it persists long enough, a recession will ensue.
But given how deeply the yield curve has inverted recently, a Fed rate cut of 25 basis points this month is not a guarantee that the yield curve will “un-invert.” It could possibly even stay inverted until the Fed’s September monetary policy meeting. If so, one would be hard pressed to find a period of five consecutive months of inversion that did not precede a recession.
If one wants to argue that “this time is different” and the current inversion will not lead to a recession, then they are arguing the economy is strong enough to withstand several weeks or a few months of restrictive interest rates. What would help this argument is an un-inverting as soon as possible; a 50 basis-point cut on July 31 would do that.
Interest rates are a relative game, not an absolute game. This seems to be lost on many that argue something to the effect that at 2.5%, interest rates are not restrictive. This is an argument based on the absolute level of interest rates and a history of where rates have been over the last 30 years.
Market participants need to break themselves of this absolute thinking and recognize the funds’ rate is on the wrong end of the relative interest rate world. It is an outlier and the yield curve and market pricing are screaming this needs to be fixed. The sooner the Fed fixes it, the better. A 50 basis-point cut fixes it better than a 25 basis-point cut.
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Jim Bianco is the President and founder of Bianco Research, a provider of data-driven insights into the global economy and financial markets. He may have a stake in the areas he writes about.
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