What The U.S. Fed’s Rate Cut Decisions Could Imply, According To Howard Marks
Howard Marks of Oaktree Capital, in his latest memo, explains what the Fed’s interest-rate management would mean for the economy.
U.S. Federal Reserve is expected to cut rates amid risks to global growth and trade war tensions with China. Howard Marks of Oaktree Capital, in his latest memo, explains what the Fed’s interest-rate management would mean for the economy, and if low rates are actually a good thing.
What The Fed Actions Tell Us
To explain how people view statements and actions of the U.S. Federal Reserve, Howard Marks cited Fed’s actions in 2007. Markets were in turmoil when the Fed cut rates after two mortgage-backed security funds managed by Bear Sterns filed for bankruptcy, and investors received the news warmly. But, according to Marks, second-level thinkers should ponder over what such actions convey.
My point is that a rate cut’s implications aren’t always as simple a matter as they may appear to be. Assuming the Fed is a good diagnostician, a decision to cut rates isn’t necessarily good news. You can argue that, if there’s trouble ahead, we’re better off with a rate cut than without one. But that still doesn’t make it good news. First, it means the Fed trouble is looming. And second, it certainly doesn’t guarantee the problem will be solved.Howard Marks
Marks highlights that 18 months after the first rate cut in September 2007—during which time ten more cuts followed, eventually taking the fed funds rate to nearly zero—the S&P 500 finally bottomed out, down more than 50 percent from where it stood on the day of the first cut.
Are Low Interest Rates A Good Thing?
Marks argued that low interest rates spur spending, lift demand for things, encourage investment on the part of businesses by reducing costs of capital and so on—all of which work for a market participant. The reduction in discount factor for net present value calculation is positive for market participants, he said.
Speaking about why U.S. President Donald Trump would want lower rates—in effect describing Trump as an active market participant and a re-election candidate desperate to have the economy looking good. Marks said:
- He’s a real estate guy, and the real estate industry lives on high leverage.
- Trump has been a substantial borrower for much of his life, so for him low rates are “all good.”
- Right now Trump is tightly focused on getting reelected, and ensuring economic growth and a rising stock market over the next 16 months is one of the best things he can do to make that a reality.
- Along those lines, if reelection is his main goal, he may be relatively indifferent as to what happens after Election Day 2020, when the scorecard he cares about most will be closed out.
Is There A Downside To Low Interest Rates?
Howard Marks cited multiple reasons on why he thinks low interest rates are undesirable and potentially harmful. He wrote:
- Low rates stimulate the economy, as described above, and most economists and business people believe there’s such a thing as the economy becoming too hot. The principal worry is excessive inflation. While some inflation is a good thing, too much isn’t. It’s generally accepted that too much of the positives described on page three can lead to excessive demand for goods and services; too-tight labour conditions, leading to excessive wage inflation; too much market power in the hands of sellers of goods; and thus rising prices.
- Too much inflation imposes a hardship on people living on fixed incomes, since their costs increase rapidly while their incomes don’t. Also, low-income households typically don’t have the means to hedge against inflation that high-income ones do, such as through investments in equities and real assets.
- When low rates penalise savers by reducing the returns available on safe instruments like cash, money market funds, savings accounts, Treasury securities and high grade bonds, savers’ alternative to accepting lower incomes is to assume increased risk in pursuit of the higher returns they used to earn safely.
- Thus low rates can lead to investment in undeserving companies and shaky securities, encourage the use of excessive leverage, and create asset bubbles that eventually can burst.
- Ultimately, investors’ tendency to reach for yield and assume excessive risk can introduce risk to overall financial stability.
- Finally, but very importantly, when interest rates are low, central banks don’t have at their disposal as much of their best tool for stimulating economies: the ability to cut rates.
Marks ends this memo with a few pertinent questions which will be answered over time and a key 'warning' from a previous memo.
Questions That Marks Poses
- Should investors be happy to see the Fed trying to prolong the economic expansion and the bull market when they are already the longest in history?
- Should Fed try to produce perpetual prosperity and permanently ward off a correction?
- And are there risks in its trying to do so?
He then gives a warning:
Finally, when I hear people talk about the possibility that the Fed will prevent a recession, I wonder whether it’s even desirable for it to have that goal. Per the above, are recessions really avoidable or merely postponable? And if the latter, is it better for them to occur naturally or be postponed unnaturally? Might efforts to postpone them create undue faith in the power and intentions of the Fed, and thus a return of moral hazard? And if the Fed wards off a series of little recessions, mightn’t that just mean that, when the ability to keep doing so reaches its limit, the one that finally arrives will be a doozy?