Heading to the exits, the Dow Jones Industrial Average plunged today 800 points to 25.479, down 3.05%, losing over 2,000 points in the last three weeks. When the 10-year treasury yielded at 1.5810% dipped below the 2-year yield of 1.583%, it signaled an increased chance of a recession. Chief Economic Adviser for Allianz SE, 60-year-old Mohamed El-Erian, sounded the alarm, not so much about a slowdown or recession but at the growing possibility that U.S. interest rates turning negative. Cutting rates 25 basis points July 31, Powell thought he was doing markets a favor, not realizing that rates were already so low they didn’t need another rate cut. Wall Street reacted harshly to Powell’s decision to cut the federal funds rate by a quarter-of-a-percent. President Donald Trump has been hammering Federal Reserve Board Chairman Jerome Powell for hiking rates four times in 2018.
Trump thought Powell’s 2018 rate hikes were unnecessary given the low inflation number. El-Erian points out the real risk of slashing rates, with interest rates in Europe and Japan already negative. Former Fed Chairman Alan Greenspan expressed concern that “no barrier to Treasury yield going below zero,” posing the real dilemma for the Fed, trying, on the one hand, to provide added monetary stimulus, while, on the other hand, keeping rates from going negative. Despite pressure from Wall Street to slash more off the federal funds rate, Powell should reconsider his next move. With interest rates already too low, the Fed might consider another round of Quantitative Easing to stimulate the economy. Greenspan expressed the real fear that interest rates could go negative much like they’ve done in Europe and Japan.. Quantitative easing would make Treasury yields more competitive again.
El-Erian worries that if interest rates go negative, they’d “take away the provision of long term protection products,” meaning, there’d be no incentive for any domestic or foreign investor to buy U.S. treasuries, or, worse yet, bank-offered certificates-of-deposits or money markets. Without positive interest rates paid to long-term investors, there could be a run-on-the-bank, much the way things unfolded after the 1929 stock market crash. Negative interest rates could decimate the life insurance industry and management of a wide range of retirement products, including annuities. Today investors still receive positive rates, though small, yields on long-term investment instruments, including money markets, CDs and various mutual funds. Powell finds himself caught between a rock-and-a-hard-place, continuing to slash the federal funds rate when it’s already at near historic lows.
Government debt, including federal and state tax-free municipal bonds, would be killed if Powell continues to slash the federal funds rate. Negative interest rates would drive investors out of the market, causing a liquidity crunch at the Fed and in the retail banking sector. “Negative yields have huge implications for how the economy operates,” El-Erian said, urging Powell to think twice before his Open Market Committee [FOMC] meets again in September. When you consider that the 10-year German bond yield was –0.657 and the French 10-year bond yield was –0.3715, Powell wants to do everything possible to stop that from happening. El-Erian doesn’t think the slightly inverted yield curve should signal slowdown or recession in the near future, claiming that negative bond yields in Europe and Japan have “distorted” U.S. bond yields. El-Erian urges Powell to reconsider his next monetary stimulus.
Powell has one option left in his Fed’s toolbox, restarting quantitative easing, where the Fed buys monthly quantities of U.S. treasuries, increasing the Fed’s balance sheet, but, at the same time, increasing liquidity. El-Erian’s concern about future rate cuts causing rates to go negative is real, considering it’s already happened in Europe and Japan. “The European Central Bank [ECB] made that mistake and they can’t get out of it,” El-Erian said. “And the Fed has to be careful not to make the same mistake,” urging Powell to stop easing U.S. monetary policy. If Powell wants a soft landing for the U.S. economy, he should start a new round of quantitative easing. With today’s 800-point drop in the Dow, all bets are off when it comes to how much selling lies ahead. Holding off on more Chinese tariffs was Trump’s way of telling Wall Street that the U.S. economy should keep rolling.
Cyclical profit-taking by Wall Street has spooked markets, driving more selling than buying. How long the selling lasts is anyone’s guess. What’s known for sure is that the price-to-earnings rations have gotten out of hand, prompting short sellers to step in and take profits. If Trump does his part to reassure markets and Powell starts a new round of quantitative easing, it’s possible for the U.S. economy to weather the current global downturn. Negative interest rates in the U.S. would be a disaster for risk-averse long-term investors, looking for reliable long-term fixed income yields. El-Erian sees nothing inevitable in the inverted yield curve leading to recession in the U.S. Working together with the Congress for more stimulus in today’s tax policy, the Federal Reserve can help the U.S. economy avoid recession. Slashing rates again, the Fed would only make a bad situation worse.
