FED INTEREST RATE CUTS-YOU USUALLY GET MORE THAN YOU WERE LOOKING FOR

Many analysts believe that the Fed will reduce the Fed Funds rate from its current 5.25% to 4.5% by the end of this year. A cut of .75%, 75 basis points.

But John Mauldin in his “Thoughts from the Frontline” Newsletter believes that rate cuts will be deeper and perhaps parsed out over a longer period of time. In the newsletter, “entitled “The Black Swan”, he states:

Right now, the market is pricing in rate cuts of 75 basis points by the end of the year and another 25 basis points within 12 months. I think that is low. If the Fed is cutting, it is because they see the economy weakening. And I think that means they will cut more than anyone expects. What is the end number? I don’t know. But I bet it is a lot lower than 4.5%.

Why? Because the credit markets are going to take a lot longer to sort out the mortgage problems than we might think. And that means that a lot of homes are not going to move for some time, which is not good for consumer sentiment or spending. And there will be substantially less mortgage equity withdrawal. As home prices drop 10% and then 15% and then 20%, boomers are going to realize that a large part of what they thought they had for retirement in the equity of their homes is not there. That means they need to spend less and save more. While that is good as an individual policy, it is rough on the economy at large. I still think this process ends in a recession.

IF PAST DISCONTINUITIES ARE ANY GUIDE…

But Mauldin’s prediction of upcoming Fed events is less a forward looking statement than a past observation. Mauldin looks back at three recent Fed Rate cuts, in 1987, 1998 and 2000.

Let’s look at 1987, 1998 and 2000. All three periods had rather solid US economies. All three had rather significant disruptions. And all three saw the Fed open the liquidity flood gates.

You can expect the same today. As I have often written, when the Fed embarks upon a new course, they will go further and the course will last longer than anyone thought at the beginning of the process. Who thought when the Fed began to loosen monetary policy in early 2001, when rates were 6.25%, that we would see 1% within a short period of time? And who thought it would stay that way for so long? And when they began tightening again? Who thought it would get to 5.25%? Back then, 4% seemed like a very high rate.

For support for his belief that Fed Rate cuts will be bigger and longer, he discusses two Authors, one of which the Author is a devotee. The other is an author of whom the Author is likely to become a devotee.

The books cited are “The Singularity is Near” by Ray Kurzweil and “The Black Swan – The Impact of the Highly Improbable” by Nassim Taleb. (A “Black Swan” is a metaphor for the unexpected, improbable event) From different starting points, both authors make the point that the business of predicting, in this case Fed auguring, is limited by human heuristics.

THE EXCEPTIONS ARE THE RULE.

Taleb argues that humans tend to think inside the Bell Curve. But the big things, the exceptional things that we don’t discount that make the biggest differences, are the driving wheels.

States Taleb:

To summarize, in this (personal) essay, I stick my neck and make a claim, against many of our habits of thought, that our world is dominated by the extreme, the unknown, and the very improbable (improbable according our current knowledge) – and all the while we spend our time engaged in small talk, focusing on the known, and the repeated. This implies the need to use the extreme event as a starting point and not treat it as an exception to be pushed under the rug. I also make the bolder (and more annoying) claim that in spite of our progress and the growth, the future will be increasingly less predictable, while both human nature and social “science” seem to conspire to hide the idea from us.

When I ask people to name three recently implemented technologies that most impact our world today, they usually propose the computer, the Internet, and the laser. All three were unplanned, unpredicted, and unappreciated upon their discovery, and remained unappreciated well after their initial use. They were consequential. They were Black Swans. Of course, we have this retrospective illusion of their partaking in some master plan. You can create your own lists with similar results, whether you use political events, wars, or intellectual epidemics.

You would expect our record of prediction to be horrible: the world is far, far
more complicated than we think, which is not a problem, except when most of us don’t know it. We tend to “tunnel” while looking into the future, making it business as usual, Black Swan-free, when in fact there is nothing usual about the future…

Unexpected events are right around the corner. 25 basis-point Fed Rate cuts may be swamped by the enormity of events. Too little coming very late.

YOU AIN’T SEEN NOTHING YET. AND WE WILL SPEED UP THE PROJECTOR.

Ray Kurzweil is a polymath, but among his poly phenomenals, he is a futurist. Mauldin accurately distills Kurzweil’s guiding thesis in the quote below:

[M]ost people project future growth in technology at today’s rate of change. (AUTHOR’S NOTE: Kurzweil would say we predict future growth “linearly”, while it occurs exponentially. Sort of like the world on compound interest.) But the rate of change is accelerating, so that more and more change is packed into smaller and smaller amounts of time. While the vast majority of the thousand times greater technological change Ray is talking about happens in the last part of this century, some of it happens in the next twenty years. How much change are we talking about? Well, from when he first penned those words, the pace of change has picked up. At current levels, that means the 20th century was equivalent to about 20 years of progress at today’s rate of change. That pace will continue to increase the amount of innovation we pack into just a few years

So while the Fed is making .25% cuts, the market could devour .50% swaths.

LAGGARD TODAY. FOSSIL TOMORROW.

All this was a lot to say before making the pedestrian prognostication that the Fed will cut rates deeper and longer. For mortgage holders with good credit, that may mean a refinancing in your future. For bondholders, that should mean a spike in the bond values. For the Lilies of the Field, who neither toil nor spin, this means nothing. That is, at least, a good thing.

REGRETTABLY, LILLIES DO NOT GROW WILD IN THE DESERT OF THE REAL. THEY MUST BE CAREFULLY CULTIVATED.