THE GREATEST SUPERSTITION
EDU DDA July 18, 2024
Summary: We are now at the stage where we can finally talk about superstition. In other words, Fed rate cuts. Why does everyone believe these have magic powers? Economic study (small “e”) almost never gives us a clear, unambiguous result, but when it comes to central bank rate policies at these times it actually does. The evidence leaves no room even for interpretation. With rate cuts on the way, let’s examine both the evidence and the rationale no matter how irrational.
The Russell 2000 had a huge short-term run as short-term Treasury yields have sunk. We’re led to believe the two are related, both a product of the changing conditions which will have Jay Powell the FOMC soon cutting rates. While the risky stock index might be thinking “stimulus”, as we know only too well bonds are doing anything but.
How does this appetite for theater survive cycle after cycle?
For stocks, the answer is quite simple. Fundamentals don’t apply, only beauty does. So long as more than enough “investors” in equities believe other investors believe everyone else buys on rate cuts then share prices can so clearly unhinge from reality. Shares are a higher form of gambling.
The reason for their higher place is solely down to the fact the house in this game is on the players’ side. Everyone is literally and figuratively invested in the shabby little guy behind the curtain. There needs to be the god-like technocrat for it not to fall apart.
Is this, then, just late-stage behavior?
The most speculative corner of the stock market is soaring at a pace not seen since the pandemic as traders race to move up their rate cut bets in a risk-on signal for the investment community.
The small-capitalization Russell 2000 Index is up 12% in the last five sessions, something it hasn’t done since April 2020, while the S&P 500 Index has gained just 1.6% over that time, and the technology-heavy Nasdaq 100 Index is down 0.3%. What’s more, the largest exchange-traded fund tracking the Russell posted the second-biggest inflow among equity ETFs last week.
For stocks, I couldn’t begin to guess if they are close to their top. Betting against them is a suicide pact, the very reason why there are no long/short funds anymore. There’s no reason to short much or anything these days because beauty can be found everywhere even among the ugliest names in the economy with Jay Powell applying so much make-up.
Setting aside the matter of equities, there is ample and growing evidence of late-stage signals where it actually counts the most – in the real economy. One of the biggest and most reliable of those warning signs is actually the very rate cuts almost everyone right now is busy saluting in one way or another.
There are two reasons typically given when trying make this irrational behavior sound rational. The first is pure ignorance; as in, hardly anyone knows economic history. Rate cuts aren’t salvation, they’re the opposite, practically the bell rung at the top. Once they start, everything has already gone wrong, way past the point of no return.
For those few who might otherwise know the history, there is the tantalizing thought over this time somehow being different. Every single other instance has led to heartbreak at the casino, but maybe just maybe there is a critical change in something substantial which will allow the narrative to overwrite reality for the first time.
Theoretically, the problem begins even before all that. Lower rates just aren’t stimulus no matter how many times you will hear that they are. This isn’t established by anything other than conjecture; literal misinformation, if you like. Models start out by assuming Fed rate cuts stimulate something in the economy solely because the Fed says so.
And since the models presume a positive effect from the beginning, their calculations show one which is then used to “validate” the theory that rate cuts are effective. It’s the equivalent of the fake Wikipedia page which fools a mainstream journalist into writing about what’s on the page if only to allow the fake page’s author to then use the mainstream published article as “proof” for what he faked on the Wikipedia page.
It is honestly no different with rate cuts. The “logic” is entirely circular.
If you want to stretch the truth a little bit, most of this mysticism traces back to the unanswered, unexplained occurrence of the Great “Moderation.” With a lack of established explanation for that period, the Federal Reserve has asserted itself – with enormous assistance from the financial services industry plus the financial media, both who have much the same vested interest in turning the shabby old guy into the all-powerful wizard – by creating a widely-shared superstition.
The same way the ultra-fan of whichever sportball team might refuse to take off his “lucky” jersey on gameday, stock investors kiss their rabbits-foot of a rate cut fantasy blissfully embracing the unscientific lunacy. And it all works really well…until it doesn’t.
The Fed had to create this myth surrounding interest rate targeting because, quite simply as Alan Greenspan openly confessed, that’s all they had left. Monetary evolution decades before the eighties had rendered the Federal Reserve something other than an actual central bank. It couldn’t impact the banking system, so it would seek to influence something else with an interest rate that in reality had already been circumvented by so much else in the eurodollar system.
Given these enormous functional limitations, Fed researchers and officials mainly led by Ben Bernanke and his usual crew of academic suspects searched for every last pontential correlation they could plausibly latch onto in order to claim it as FOMC territory (I wrote several months ago about this process in the 90s with Ben Bernanke trying desperately to usurp oil prices in order to assert it had been higher interest rates what caused prior recessions).
THE MEDIA WANTED AND EVEN NEEDED THE MYTH AS MUCH AS THE FED DID AND DOES
Financial media bought into the myth because it wasn’t just good for business, it became their business.
The fact of the matter is the late-stage signals are getting stronger all the time. I’ve covered swaps and copper-to-gold just this week, though I should mention that copper crashed today (after the Third Plenum predictably disappointed) sending the ratio with gold plunging to a clear multi-year low. Another highly deflationary signal which further corroborates swaps, the Treasury bull, even the suddenly buoyant dollar defying all this rate-cut chatter.
Setting aside the “good times” for a moment, what about the performance of cuts during the cyclical troughs? You’d think there’d at least be some wiggle room here of just the kind Bernanke repeatedly exploited, some vagueness by which to base at least a meager case to start somewhere for the rate-cutting crowd.
While economics (small “e”) and finance rarely offer such uniformly conclusive and unambiguous determinations, in this instance that’s just what we have. In every cycle since the beginning, going back to 1982, the Fed has cut rates and unemployment has surged anyway as the recessions causing the rises in joblessness manifested and kept going regardless of interest rate policies.
Market interest rates were pricing the consequences of the recessions, not the policy cuts. Bonds have it right in that low rates don’t stimulate anything. They are instead a reflection of bad conditions, both in terms of Fisherian deconstruction of bond yields (lower growth and inflation expectations) as well as understanding Fed policies will eventually be a reaction to the same.
If we are being completely fair – and there is no reason we should given the topic and the level of dishonestly often displayed surrounding it – the FOMC didn’t specifically set out to target the fed funds rate until around or after the 1982 recession. By Greenspan’s again admission, it was that year once the worst of the downturn had pummeled the economy officials began playing around with the only tool they had left.
While there may not have been a specific target in place, the Fed under Volcker did let ST rates go lower at the same time encouraging them. And, of course, it didn’t work.
The 1981-82 downturn stood as the worst cycle since the 1930s until 2008 – and even then, the earlier one outdid the Great “Recession” in terms of the unemployment rate (though not job losses either outright or when measured in percentage terms). Lower rates didn’t help, leaving policymakers and Fed-adjacent academics at best trying to claim some form of “jobs saved.”
Before 1990’s S&L recession even started, the now-Greenspan Fed was already experimenting with rate targeting. They had been attempting to stave off a restarted Great Inflation in 1988 and 1989 with rate hikes (even at that late date, Economists still weren’t sure it had actually ended because they had no way of knowing what the monetary system was doing therefore chances for legit inflation risks), then reversed course fearing weakening during the second half of ‘89.
By early ‘90, officials thought they’d achieved their first soft landing and while they were congratulating themselves the recession instead showed up in July. Rather than considering it a mistake from which to learn something, of course those at the Fed immediately blamed Saddam’s invasion even though there had been numerous warnings months before Americans even knew where Kuwait was on a map.
Once the unemployment rate began to rise, the fed funds target began to fall in near-perfect inverse correlation. Yet again, the rate cuts failed to produce any tangible result, only leaving the “jobs saved” conjecture.
A decade after the eurodollar’s heyday, the real reason (one of them) behind the Great “Moderation”, as the dot-com stock bust was getting serious and the idea of the Greenspan “put” was widely shared (superstition!), this time the rate cuts began ahead of the contraction not that it would ultimately make any difference.
The Fed began in early January 2001, almost a year into the stock bust, yet not only did dot-coms keep busting for another two years the economy took the hit throughout 2001 and stayed down right through 2002, as well. The lack of recovery even convinced Greenspan to put his rate target down all the way to 1%, an unthinkable low at that time.
Again, to what effect? None. Neither stocks nor the economy were positively impacted.
Ben Bernanke’s Fed attempted something similar though under much different and more dangerous circumstances. This time rate cuts were supplemented by “liquidity” measures which did as little for effective liquidity as the rate cuts helped out an economy careening toward another massive downturn.
The actual track record is unusually and absolutely clear. Just look at the nearly perfect inverse correlations each time between the fed funds targets and the unemployment rate. As the latter goes up, the former goes down in response. If rate cuts worked, the unemployment rate would never go very far. It’s the economy that controls the Fed.
To bring this DDA back to the beginning, here is (below) the modern version of the stock market and its performance as seen by the S&P 500 index during these times when unemployment is rising. Since we know policy rates are falling rapidly at the same time, they are no help to either stocks or American workers.
Yet, somehow, the superstition is as strong as ever.
Instead, the argument will stick to the soft-landing scenario so as to avoid this hugely uncomfortable truth; how there is no reason to believe there in recession or anything other than a gentle slowdown in 2024.
The Fed’s rate cuts are said to be a little house insurance to make sure not realizing the Fed each of the past instances made the same claim at least in the beginning while they still could (just look up the term “soft landing” before each business cycle trough).
The coming rate cuts say otherwise. Once they start, history shows they don’t stop at least not when unemployment is doing its thing. Long after it’s all over, those at the Fed engage in the institution’s one constant longstanding tradition best described by Milton Friedman in his 1963 opus A Monetary History:
In other words, just as we see in the actual data, when the economy is doing its thing and expanding with no regard to Fed policy one way or the other, the Fed will claim correlation is causation intentionally taking full credit for the expansion (Bernanke was the absolute worst about this) to bolster its mysticism. Once the expansion inevitably turns, officials decry how little they can do about the inflection as it gets ugly regardless of what they do.
They’ll say we’re just lucky there were able to save us a few jobs.
Rate cuts aren’t a good thing; they are pure superstition. That’s not my determination, history and empirical fact unambiguously say so. We can and should argue about whether we are facing that kind of potential in the first place, but not what happens if it turns out we really are.
I see the turn in the marketplace(s) plus the corroboration in the macro data, including jobless claims yet again, and I think it’s time to revisit everyone’s favorite lucky jersey.
