The Fed’s COVID19 Rate Cuts Can’t Stop What’s Coming

Stock market indices Friday. This isn’t normal. (Yahoo Finance)

Well, it finally happened. After years of whining from the Commander in Chief, the supposedly independent Federal Reserve agreed today to cut interest rates to near zero. If the objective was to stave off economic recession from COVID19, it’s far too late for that. Numerous states including Ohio and Illinois have announced mandatory closures of public spaces like restaurants and bars to stop the spread of the virus. While it’s unlikely that we will face shortages of consumer goods in the near term, panic buying has been rampant.

FED RATE CUTS: A BRIEF INTRODUCTION

Low interest rates mean that borrowing is more affordable. It also means that debt-financed spending is cheap– and therefore profligate. “Spending” can be a good thing. It can also be a good way to rack up dangerous amounts of debt. The Fed ostensibly should be focused on stimulating growth, but also being a responsible steward of the economy. It is currently being neither in its captivity to the narcissism of the current President.

The Fed ostensibly should be focused on stimulating growth, but also being a responsible steward of the economy. It is currently being neither in its captivity to the narcissism of the current President.

Remember in the early 2000’s, all of those well-advertised offers of Totally Free Checking accounts? Fed interest rates peaked just over 5% in 2007. Higher interest rates from the Fed means higher rates paid on debt borrowed. It also means higher rates paid to consumers in savings accounts. This is a tradeoff. These days, you can get great deals on financing– things like, say, 60-month 0% APR on a new Ford F150. But if you want a return on your savings, you have to look toward the stock market.

THAT’S THE POINT

This is exactly what Trump is going for. The President is reportedly obsessed with the stock market. He tweets about it all the time– like last week, tweeting about the largest one-day point gain in history, just one day after the largest point drop in history. Volatility would seem to be the new normal. Indeed, so much money has been put into the stock market that some corporate debt has been driven into a negative yield. In other words? People are betting so hard on private sector growth that they are paying corporations to hold their money.

This is absolutely nutty.

The Fed lowers interest rates in order to stimulate economic growth, as lower financing costs can encourage borrowing and investing. However, when rates are too low, they can spur excessive growth and subsequent inflation, reducing purchasing power and undermining the sustainability of the economic expansion. When there is too much growth, the Fed can then raise interest rates in order to slow inflation and return growth to more sustainable levels.

In addition to the fact that the market has been at historic highs– without even thinking about the thread of COVID19- growth has its limits. Nowhere is this more apparent than in the tens of trillions of dollars of corporate debt that companies have racked up in the past 12 years to finance growth.

It doesn’t take an expert in corporate finance to understand the maxim that whatsoever a man soweth, that shall he also reap

ANYWAY– WHAT ABOUT THAT CORPORATE DEBT?

The only way the current debt bubble would have been manageable is if earnings growth continued forever and ever. When we went from a partial-economy recession in transportation and manufacturing to what analysts call an “earnings recession,” in which earnings slow, we hit Peak Stock Market. But investors didn’t particularly seem to care. Analysts couldn’t get enough. Financial journalists waffled and financial pundits would say, “yeah, well, it’s high, but you gotta keep investing!”

And so up and up the market continued, stoked by gradual rate cuts and corporate tax cuts. (In a red-hot, growth economy, most economists agree that the government should enjoy the ability to raise tax revenue and should raise rates to temper the market).

But things can turn on a dime. The situation with COVID19 went from “concerning” to a full-blown, national crisis within two weeks. During this time, unexpected OPEC price cuts sent global markets into a tailspin. It is not entirely why this happened, as OPEC had proposed production cuts in December to boost prices. But the consensus is that Kingdom is essentially playing chicken with Russian and US production, trying to flex their muscles at an economically tenuous time for the country.

Further souring the crude, as it were, Saudi Aramco, which became the largest publicly traded company in the world when it delivered its IPO last December, just delivered a bombshell of a disastrous earnings report. (I predicted last year when this IPO was made that this might well break the economy because of both how large the company was, but also because of  how much of the economy is dependent upon oil). The price cuts have sent shockwaves through the US energy sector, hammering not only oil stocks but even solar companies as well. This is a huge problem when the US is trying to push for energy independence (unless the federal government wants to propose, say, a carbon tax– which seems unlikely in this administration).

WILL COVID19 CRASH THE DEBT PARTY?

CNN noted that there is $19 trillion in risky corporate debt— an economic threat without a pandemic. Much of that debt was financed based on the prospects of essentially unlimited earnings growth. And that growth comes largely from consumer spending, which is the cornerstone of the US economy. We like to buy things. So, every percentage point of reduction in consumer spending represents hundreds of billions of dollars. The complete and temporary shutdown of the trillion plus dollar travel industry is perhaps a larger immediate threat.

Before COVID19 began to gnaw at the public psyche, cursory analysis revealed that a double digit percentage of the largest 50 companies were determined to be unable to be able to meet short-term debt obligations. A number of these companies account for percentage points of the US workforce– like Wal-Mart or Home Depot. Interestingly, very few people have seemed to care until the past few weeks.

How do you manage debt? You shrink your balance sheet. This involves layoffs aplenty.

There may be a silver lining, though. The collapse of any debt bubble requires that large amounts of debt be written off. This could involve a large portion of the nearly $15 trillion in household debt currently outstanding, which includes mortgages, student loans, medical debt, and unsecured debt– like credit cards. This could hypothetically have a benefit for American consumers– thinking about wealth transfer as a type of federal stimulus, for example. Forgiving 10% of this $15 trillion in debt would work out to just under $5,000 per person in this country.

THE PUBLIC BURDEN

The public burden should not be underestimated. Trump’s tax cuts inflated an already sky-high market– and at massive public cost, no less. A trillion plus dollars essentially went from consumers to the government, and back to corporations, who then invested most of it into stock buybacks. This has left the federal government broke– with a trillion-dollar deficit and therefore minimal opportunity to facilitate stimulus package in the event of the shit hitting the fan (an event that seems to be occurring as we speak). There’s also the national debt, which Trump has overseen increasing by 15-20% since he took office. (Notably, he pledged to eliminate both the deficit and the national debt).

So, it’s unclear what is coming next. But at this rate, we can probably look forward to a ton of corporate debt defaults, more market downside, and, depending on how disastrously the Fed manages things, an inevitable onslaught of inflation. There is already evidence of an unusual cash crunch. If you’re invested for the next twenty or thirty years, don’t worry too much. But if you’re at or nearing retirement age and have reservations, it would be prudent to assume a more defensive position in savings. If you don’t have savings, all you can do is assume a conservative position and follow the best practices for managing life during COVID19.

And in the mean time– hold onto your hats.

(Financial disclosure: I am short AMD, HYG, SPY, and V, and long SJB, VXX, TVIX, and various components of .INX, .RUT, .IXIC. in other words, I’m betting for market conditions to deteriorate, including but not limited to corporate debt defaults).

Nat Zorach

Nat M. Zorach, AICP is a city planner, community development professional, and MBA candidate at American University's Kogod School of Business, based in Detroit.

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