There is no day now when we do not hear from either Lutnick, Bessent, or Trump himself a verbal broadside towards the Federal Reserve, where, let’s not forget, Donald Trump himself nominated the chairman. Why so much beef against Jerome “Burns” Powell? According to them, the FED should be cutting rates all the way down to 1% and save the US ~$700 billion a year of interest expenses on its government debt.
First of all, if the FED cuts interest rates, that doesn’t imply investors would be willing to allocate capital in US T-Bills or US Treasuries in the same amounts they do at the current yields. Here is one key element that many people in power, and not only in the US, but across the globe, fail to understand: in a free market, interest rates are one of the most important factors that determine the allocation of capital across asset classes.
- If interest rates set by central banks are too low, investors will naturally allocate more capital to asset classes with a higher expected return.
- Fixed Income interest rates are always nominal, which means that investors will take into account the level of inflation to determine whether or not to invest in an instrument that is designed for capital preservation, not for capital gains. If you think that investors make their own decisions based on the CPI level that the US BLS communicates every month, then it’s time to stop believing in fairy tales. Any investor makes an investment decision based on the level of inflation he or she perceives in their day-to-day life. As a consequence, even if the BLS says prices did not grow this month, the investor won’t be able to ignore how much they spent compared to their income from work activities combined with their income from investment activities. The moment a bank deposit, a T-Bill, or a Treasury note no longer pays enough to satisfy investors’ demand for capital preservation and eventual appreciation, the investor will naturally drift away to other asset classes.
- Other asset classes like stocks, crypto, or corporate bonds naturally provide higher returns simply because they are riskier. Here is another area where interest rates are key again, because if interest rates are too low, not only strong companies and projects, but also zombie companies will be able to access funding, remaining operational instead of going bankrupt. This is a clear distortion of the risk profile that is being artificially lowered, creating the false impression that higher returns can be earned for the same unit of risk that a (in theory) risk-free government bond can provide.
A second and very important element is the treatment of the FED as if the institution were just the US central bank and the repercussions of its actions don’t go beyond the US borders. As I said many times before, it is wrong to look at central banks’ policies in isolation when the global financial system has become so interconnected. Why do you think the FED rate hike campaign has been so ineffective this time around to tame demand for speculative asset classes, and the stock bubble is lasting so much longer than many, including myself, expected? Because other central banks, especially the Bank of Japan, keep printing too much currency that does not stay within the national borders, but keeps flooding the global financial system with cheap capital.
A third critical element so many are failing to understand is that central banks lowering rates when the demand for risk assets is very high, if not totally irrational, like now, does not help the real economy at all, but quite the opposite. Why? Because lowering interest rates means loosening financial conditions even more, it increases the supply of currency in the financial system. When stocks and other risk assets are such a powerful magnet for capital, lowering interest rates will counterintuitively be detrimental for the real economy because resources will be siphoned away from it towards speculative and unproductive assets whose prices become more and more inflated compared to their real economic value. This is an example of what I am talking about and that I shared on X during the last weekend:
“People who buy Nvidia now, I heard many did recently for the first time, usually expect a 20% return in a year. That implies a 1 trillion USD increase in market cap.
Now think about this: will Nvidia be able to increase its real economic value by 1 trillion USD in 12 months? This without even considering that this company clearly doesn’t carry a 4 trillion USD economic value by far with ~150bn USD of yearly revenues (of which a big chunk very questionable) and 36,000 employees.
Putting this into perspective, if we use GDP as a yardstick, Nvidia alone would already be the 4th largest economy in the world. All mag 7 value combined is getting closer to the GDP of China, a country of 1.4 billion people.
This is not overvaluation, not even a bubble anymore, this is simply stupidity and ignorance by the most about basic economics rules and math.
Enjoy your paper gains folks, but beware that likewise paper these will quickly go up in flames as soon as a little spark will get close enough to set fire on them”
I could spend hours listing all examples of incredible capital misallocation from Palantir to OKLO, from more and more companies raising capital to pursue a Bitcoin treasury strategy to credit spreads trading at rock bottom levels despite the poor shape of the real economy.
Now, what do you think is going to happen if in the current environment, the US Administration is successful in forcing the FED to cut rates? We already saw what can happen just last year when Jerome “Burns” Powell agreed to cut interest rates, with the obvious outcome of pumping stocks heading into the election for the sole purpose of supporting the Democratic campaign and undermining Donald Trump’s chances of reelection.
This is what’s going to happen if the FED caves and cuts rates as the current administration wishes:
- Stocks, crypto, and other risk assets will see a boost in capital inflow, distorting valuations even further
- In order to achieve a ~700bn USD nominal saving in interest rate expenses on government bonds, the US administration will have to front-load all the funding towards short-term T-Bills because without a strong yield curve control in place, investors will be more and more unwilling to hold long-term US treasuries, dumping them and pushing long-term yields higher.
- Other countries, which have already decreased their total holdings of US debt from ~50% to ~30% in just a few years, will be even more motivated to look for more reliable foreign reserves alternatives. Gold obviously will be the asset that will see a pickup in demand as a result.
- Retail investors, despite their apparent bottomless appetite for risk assets, won’t be eager to hold their liquidity in deposits or T-Bills, which in case of sharp rate cuts will be an even worse protection against inflation than what they are now. As a result, this will boost demand for very liquid but better alternatives like Silver.
- Fixed Income investors, who aren’t infinitely foolish, will compensate a drop in rates with an increase in demand for a higher credit premium to corporates if they wish to attract capital to raise or refinance debt away from all the other more enticing alternatives I mentioned before. However, it is when credit premiums start to price properly that corporate defaults start triggering, not the opposite as it happened every single time right after the FED started to cut rates aggressively.
All in all, the US might be able to achieve a cost saving in government debt cost for a short while, but then what’s going to happen when the bubble, which in the meantime grew larger, ultimately bursts? Like it happened in 2008 after the FED started to cut rates in 2007 or in 2020 after the FED started to cut rates in 2019, the ultimate cost for the economy will be immensely greater than the brief period of savings for the public budget. Clearly, what the FED should be doing instead right now should be to hike rates and burst the speculative bubble, first containing the bailout costs needed to keep the economy afloat afterwards. But hey! Is there ever going to be a politician willing to risk such a move without the certainty that the economy is back on its feet by the time the next elections take place? Of course not, especially in the West. This is why we can rest assured that the efforts to keep this bubble inflated as long as possible with little to no benefit for the real economy will carry on until this whole unsustainable structure crumbles under its own weight.
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