This week, I’m going to send out three video editions, because what’s in front of us is very important.
We’ve got the Federal Reserve board meeting, with a widely expected interest rate cut… while everything seems to be running smoothly in the markets. And I’ll need you to remember one thing…
The Fed exists to save the banks.
And today, I’ll explain why that gives me a strong whiff of September 18, 2007…
Check out my video below, or scroll down to read the transcript.
Transcript
Hey, good morning, folks. This is Jeff Clark. Listen, we’ve got a very exciting week in front of us, mostly because the Federal Reserve Board is meeting this week, and they are widely expected to lower interest rates by either 25 or 50 basis points on Wednesday. And this is an interesting situation, because if we’re to believe the government statistics, you know, the economy is doing great. You know, we’ve got GDP running about 2, 2 and a half percent.
We’ve got inflation seemingly under control. According to the government, we have unemployment around 4.1%, which is historically low. And we have the stock market just a chip shot away from all-time highs. So everything seems to be running quite smoothly, which begs the question, why would the Fed be lowering interest rates? Because typically, according to the textbooks, the Fed lowers interest rates when there’s an economic situation where they need to help spur the economy. That doesn’t seem to be, at least on the outset, what we’re looking at right now.
The Fed Doesn’t Exist to Save the Economy
But maybe, and this is again according to the textbooks, maybe the Fed is doing this because they see something the rest of us aren’t privy to. Maybe they have access to information that tells them that maybe there are maybe a couple of problematic items that are going on in the economy. And so they’re trying to get ahead of that by lowering interest rates, and therefore saving the economy.
Now, what the textbooks don’t talk about, though, is that the Fed doesn’t exist to save the economy. The Fed exists to save the banks. And whatever the Fed does with interest rates, the design behind that is to benefit the banks.
And whatever benefit that might have in the economy, while welcome, is coincidental at best. So if there’s ever a decision that has to be made by the Fed, whether to help the economy or help the banks, we’re going to help the banks first, and we’re going to hope the economy comes along with it.
And if you need proof of that, all you have to do is go back to the last time the Fed started lowering interest rates.
The last interest rate declining cycle started on September 18, 2007.
And that’s an interesting coincidence because back on September 18, 2007, you had the economy looking pretty decent. You had unemployment down around 4.25%. You had the stock market within a chip shot of all-time highs, and the Fed lowered interest rates on September 18, 2007.
They lowered the interest rate by 50 basis points. And the reason they did that is because they saw some problems with the banks in regards to residential real estate mortgages.
So they were trying to get out ahead of that. And, of course, what happened afterwards was, you know, the Great Financial Crisis and everything that blew up in 2008 and whatnot.
So in the back of my mind, when I hear that the Fed is lowering interest rates, or I see that the Fed is lowering interest rates into an economic situation that doesn’t really demand that to happen, my question is always, “why are they doing that?” And if you understand that the Fed exists to help the banks, then maybe that gives you a little bit of a clue as to what’s going on.
Now, I’m going to share my screen with you because we’re going to talk about the stock market. We’re going to talk about where we are right now, and where we can go. So let me get my typical charts out here.
So this is the chart of the yield curve, and we’ve seen this, you know, every time we’ve held these meetings I’ve showed this to you, and this is an inverted situation. This is the long-term interest rates. The 10-Year Treasury Note, minus the 3-month Treasury Bill.
This is the yield curve, and the yield curve is usually a positive number which makes total sense because if you borrow money, or if you lend money, let’s put it this way. If you lend money or put money into a bank CD, you expect that if you put your money into a 10-year CD, you’ll get paid a little bit more than what you would get in, say, a 3-month CD.
So the yield curve is typically upward sloping, it’s a positive number. And for the past 2 years, basically, we’ve had a negative yield curve. We’ve had a situation where these short-term rates have been higher than the long-term rates.
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How the Fed Manipulates the Yield Curve
That’s abnormal.
Of course, it’s existed for so long that it seems to have become normal for most folks… they don’t know any different. But the reality is that’s an abnormal situation, and usually, it signals that something is off somewhere in the world of financial markets.
And if we go back to 2007, that’s where this little blue arrow is. Here you see, at the start of 2007, we were in an inverted situation as well, and it was September, just to the right of this blue arrow – September 18, 2007. The Fed lowered interest rates.
Now, what’s interesting? I was going back over the weekend, I was reading a bunch of news articles that were published on the day that the Fed lowered interest rates in 2007, and it talked about how it was relatively a surprise.
A lot of folks were expecting the Fed to lower rates by 25 basis points, and the Fed lowered them by 50 basis points, and that set off a level of excitement.
The stock market rallied, and we’ll look at a chart of that in just a moment. But it created a situation that helped prompt the yield curve to go back into an upward, sloping situation. It went back into the positive area here, and you’ll notice how quickly the yield curve went positive, and how quickly it advanced from there.
And this is something I think merits paying attention to on this Wednesday when the Fed is expected to lower interest rates by 25 basis points. That’s a lot. They’re guaranteed to do that.
I shouldn’t say guaranteed because who knows? That’ll come back to bite me. But basically, the market fully expects a 25-basis point cut. And it’s growing to expect a 50-basis point cut.
And that’s sort of the enthusiasm behind the market last week is, you know, as rumors started to grow that we might get 50 basis points everybody got excited and started rushing into bonds and stocks and all that sort of stuff. Now let’s talk about what the Fed can actually do here.
The Fed doesn’t control the interest rate environment; the Fed controls the discount rate, which is what it charges its banks on loans.
The Fed Funds rate is the overnight rate that one bank will charge another bank on an overnight loan. The Fed sets a target for that. They can’t just arbitrarily say, “Oh, we want to lower it to 4 and 3 quarters,” and it magically happens.
No, but in order to reach that target, the Fed actually has to go into the market and do things with securities to adjust the prices so we get to that target point. So what the Fed does if they want to lower the Fed Funds rate is they go into the market and they buy the short-term securities.
By buying it, they raise the price of those securities, which lowers the yield. So that’s how you get lower interest rates. The Fed goes into the market and starts buying.
Now, the question you ask yourself is, “where does the fed get the money to do that? Where do they get the money to buy these short-term securities.”
Now, back in 2008. Well, I won’t even go to that point just yet.
Typically the Fed has to sell something else. So what happens is the fed sells longer-term securities, and uses the money to buy the short-term securities.
And so what happens is by the Fed selling long-term securities. It lowers the price of those long-term debt, which increases the rates on those short on that long-term debt, and then it buys the short-term debt, which raises the price of the short-term debt, thereby lowering the interest rate on the short term debt.
So you create a situation where, when the fed lowers the Fed Funds target rate, it’s going to lower the short-term rate. And, by the way of open market operations, it raises the longer-term rate.
So you get a more normal shaped yield curve. So that’s why back in 2007 we saw this very rapid expansion in the yield curve, and I think we’re headed for something along those lines right now.
The complication back in 2007 and 2008. I’ll just say this as a note is again typically in order for the fed to be able to buy a short-term security, they have to sell another asset, which is typically a long-term security.
In 2008 we had what was called “quantitative easing,” which is when the Treasury basically printed money gave it to the fed and the Fed used that money to buy the short-term rates so they didn’t sell the long-term rates.
There’s Difficulty Ahead
We don’t have that situation currently. And I think if we ever went back to that situation you would see a maybe a little bit more of a panic in the markets, because that’s not something that should happen.
In any case, that’s why I am looking for this yield curve to very quickly get back into an upward slope to get to go positive again.
That is I believe, a negative for the stock market, because typically when you go from an invert position to a positive position, as we did in 2001, as we did in 2008, as we did just prior to covid, which was an odd coincidence.
And we’re looking to do here again. Those three previous times, those were relatively bad times for the stock market.
So keep that in mind in the weeks ahead, because I think we are headed for somewhat of a, oh, let’s say, a difficult time in the stock market.
We’ll just call it that.
We hope you have a wonderful trading week.
Regards,
Jeff Clark
Editor, Market Minute