On Tuesday, the Federal Reserve announced emergency interest rate cuts amid a worsening coronavirus situation. Shuttered Chinese factories, negative bond yields, and record-setting losses across all major US indexes tell a story of an economy in decline. In response, the Fed has made it cheaper to borrow money by issuing the first emergency rate cut since the late-2000s global financial crisis. 

The real terror is that the stock market didn’t seem to notice. The S&P 500 fell 2.8% on Tuesday before rebounding to a 0.9% loss by closing time. The NASDAQ Composite and the Dow fell 1.6% and 510 points, respectively. Seeking relative safety, investors turned to bonds.

The Yield Curve: Finally Straightening Out?

The good news out of this week is that the US Treasury yield curve has moved out of its inverted position. Today, 10-year treasuries boast a higher yield (1.039%) than 2-year bonds (0.8%) and 3-month bonds (0.73%). When long-term treasuries have lower yields than short-term bonds of the same credit rating it implies there’s a higher risk premium on long-term debt. In other words, the further investors look into the future, the less confidence they have. 

Inverted yield curves have preceded every US recession since the Great Depression. While they don’t spell doom for the economic outlook, inverted yield curves generally signal a turning point in the business cycle. Fortunately, however, the bond yield curve has reverted as investors have fled the stock market and rushed to bonds amid the coronavirus’s spread into European and Asian markets.

The Wrong Tool for the Wrong Problem

Does the Fed see something the rest of us aren’t? Market watchers are right to question the Fed’s motivations for prematurely cutting the overnight rate by 50 basis points, as opposed to the more widely anticipated 25-point cut. The Fed will meet on March 18, where they were originally expected to make a relatively modest adjustment to the overnight rate. Why then have they issued an emergency rate cut two and a half weeks earlier than anticipated? 

In short, the Fed likely expects an enormous cessation of economic activity. It is taking early precautions to minimize the fallout and achieve a soft landing instead of a full-on recession. Cutting the federal benchmark rate is like giving a booster shot to an economy in the crosshairs of a global virus. It’s the central bank’s first line of defense against averting a financial crisis. 

The issue is that low-cost federal funds are the wrong tool for the wrong problem. No interest rate cut is going to fix broken supply chains or revoke business travel restrictions. No amount of cheap money is going to trickle down to individuals from cash-hoarding businesses that could be reinvested to increase productivity or passed onto their workers in the form of increased wages. 

Ballooning the money supply is the wrong policy tool for an economy plagued by supply chain disruptions, reduced consumer and business confidence, and factories running below maximum output. The Fed’s rate cut should be seen as an effort to rebound an ailing stock market rather than a tenable long-term solution for an economy with precarious fundamentals.

With 940 of the Fortune 1000 companies depending on Chinese supply chains to manufacture or distribute their products, it stands to reason that many major US employers may soon run into capital constraints. Chinese factories and production centers in central Hubei province are shuttered and workers are locked out of their jobs, but it isn’t due to a lack of Western demand. 

Pumping money into the system won’t fix a problem caused by a global pandemic. It’ll only buy weeks or months of relative stability with the hope that international containment efforts succeed—or, you know, until the end of the election cycle. 

Fixing the Fed: A Physics Lesson

In physics, the law of conservation of energy holds that the total energy of a system cannot be created or destroyed, only moved. There’s a parallel here to monetary policy. 

Low federal fund rates, as a monetary policy tool, are designed to spur investment and economic activity. However, monetary policy cannot create economic activity, only move future growth forward—much like the total energy in an isolated physical system. 

To quell the threat of slower economic growth, central banks around the world have launched aggressive rate cuts with some pursuing zero interest rate or even negative interest rate policies. In doing so, they’ve effectively mortgaged their future. Like European central banks, the Fed is fast-forwarding all possible economic activity to the present and given rise to an economic environment that depends on rock-bottom interest rates to function.

This week’s rate cut indicates that the Fed has lost confidence that the economy can grow with interest rates above 1.25%. Instead of normalizing interest rates and cleansing the economic system of weak actors and zombie companies dependent on low-to-no interest rates to survive, the Fed has opted to acquiesce to the trend of inching rates toward zero with the hope that it will buy us enough time for coronavirus fears to settle. 

A Virus Of Its Own

Fed Chairman Jerome Powell remarked on Tuesday that the “fundamentals of the US economy remain strong.” Sound familiar? In 2007, future Fed chair Ben Bernake denied the development of a national housing bubble and praised the 2005-2006 housing market as a signal of strong economic fundamentals. 

The Federal Reserve is at the center of a liquidity trap and oversees a currency facing imminent risk of devaluation. Equity and real estate bubbles are side effects of cheap liquidity and a low interest rate environment.  The Fed’s balance sheet currently sits at $4.2 trillion, only $0.3 trillion short of its all-time high following the global financial crisis. Clearly no amount of reassurance from the Fed will change the fact that the US economy stands on shaky ground. 

Basic Keynesian economics tells us that with cheap money comes cheap loans. With more loans comes currency inflation. With currency inflation comes diminished currency value. The less a currency is worth, the more currency pours into real stores of value such as gold, silver, and real assets. In the weeks ahead, we can expect more risk-averse investors to put their money into precious metal IRAs as a blue-chip hedge against inflation and volatility. 

With Tuesday’s move, the Fed’s strategy is clear: throw more dollars at a diminishing supply of goods and services. The result will likely cause severe inflation unless the disruptive effects of the coronavirus soon abate. With this in mind, it’s appropriate to ask whether the Fed’s most recent rate cut is caused by a virus or is the cause of a virus all its own.

 

Liam Hunt

Liam Hunt, M.A., is a financial writer covering global finance, commodities, monetary policy, and millennial investing. His commentary and analysis have been featured in the New York Post, Reader's Digest, Fox Business, Yahoo Finance, and Forbes.