Exactly one year ago, a parade of “experts” was making the rounds on various popular TV networks advocating for a 75 basis point emergency FED rate cut to troubleshoot the crisis in the global JPY carry trade scheme. At that time, traders in the futures market priced a 60% probability of it happening. This is what I wrote a few weeks after those events in “IF THE FED CUTS RATES, THE DAMAGES WILL BE FAR GREATER THAN THE BENEFITS“:
“Thank God, for once, the FED didn’t do something stupid for the sake of calming hysterical crybabies. Why would a FED emergency rate cut two weeks ago have been the equivalent of throwing gasoline on the Japanese wildfire? Because decreasing the rates differential in the short end of the yield curve, the one with the greatest impact on FX rates, between the US and Japan would have strengthened the JPY even more against the USD, increasing the volumes of JPY carry trade positions forced to be unwound.”
However, one month later, in September 2024, the Fed caved to the Biden administration’s pressure to cut rates, fueling already overheated stocks and triggering a rally in the hope of regaining electoral consensus ahead of the November presidential elections, in an effort to counter Donald Trump. At that time, I wrote about how “FED ACTION TODAY MARKS THE BEGINNING OF THE END OF THE FIAT MONETARY SYSTEM EXPERIMENT” highlighting these 3 important elements:
- After the FED rates cut announcement, US Treasury yields rose sharply, instead of coming down as all of Wall Street was expecting, “because this action will obviously flare up inflation that, to all those who live in the real world, is much higher than the bogus data published by the US BLS”. One year later, I believe there are not many people left willing to argue with me about the reliability of US BLS data.
- The FED signaled that the financial system could no longer sustain a normal level of interest rates.
- The FED signaled that the economy could no longer sustain a normal level of interest rates.
In “THE US YIELD CURVE IS SCREAMING “DANGER!” AND ONCE AGAIN NOBODY IS LISTENING” which I wrote a few weeks before the FED cut rates, I warned:
“We just saw above that when a bull flattening of the yield curve occurs, it tends to anticipate an imminent FED rate cut, but at the same time, it also anticipates a weakening of the underlying economy. Today’s situation, though, is very special because central banks let the inflation genie out of the bottle and, despite the constant efforts by governments, central bankers, and MSM to make everyone believe inflation has been put under control, the reality is very different and the genie is still very free. As a consequence, a FED rate cut, combined with a very unique and fragile equilibrium in financial markets, can be particularly damaging this time.”
When the FED cut rates back in September last year, the yield on 10-year US Treasuries stood at ~3.7% and the one on 30-Year US Treasuries stood at ~4.05%. Today, these stand at ~4.2% and 4.8% respectively. What do you think is going to happen in about one month’s time if the FED moves forward with unnecessarily cutting interest rates again, as traders wish so badly, consequently pricing in the futures market a ~90% probability of it happening? Of course, long-end interest rates will continue to see pressure to go higher. Why?
- Traders will continue betting on the stock market bubble to continue inflating and as such they will shift their allocation more towards risky assets rather than “safer” US Treasuries that will be sold in the open market, prompting yields to rise.
- Foreign investors, especially foreign central banks, will know this move is going to re-ignite US inflation (that already stands at much higher levels than what is reported by the BLS), and as a consequence, they will continue trimming their US Treasuries holdings because they are a worse and worse tool for capital and economic wealth preservation. This will add pressure to long-end yields to rise.
- In order to save on nominal interest expenses the US Government pays every year, the US Treasury Department will continue on the recklessly dangerous path Janet Yellen embarked on for US finances during Biden’s administration: front-loading US debt refinancing in US T-Bills, decreasing the proportion of debt financed with more stable long-dated US Treasuries. This is a dangerous bet because it assumes investors will be happy to swallow that extra supply of T-Bills, being content with real negative interest rates (due to high inflation). Furthermore, it assumes banks’ demand for T-Bills will be rising while every single time the yields on these drop, the ones on deposits follow, prompting depositors to shift their savings toward what they perceive as better risk/reward opportunities (in this case, a lot of retail will favor stocks). Many banks on their own are already hitting the maximum limit of capital they can allocate to buy US debt, so their proprietary demand will fall as well. Putting all this together, you can understand there will be a massive and growing gap in demand for the growing supply of T-Bills in the market. Who do you think is going to fill that gap? Of course, the FED, but it will be able to do so only by printing more USD and increasing the money supply in the financial system.
- The consequence of what I just described will be increasing pressure on the USD to devalue, but every time this happens, other central banks react and try to weaken their own currencies too to protect the value of their economy’s exports towards the US. Such a dynamic will increase the money supply in the global financial system even more, undermining the reliability of fiat currencies as a store of value. Do you expect investors will just sit there on their government debt holdings and see their real value quickly evaporate because of monetary inflation? Of course not, which is why the already high demand for alternative stores of value like gold and silver will increase even more.
- What about the impact on US debt and US deficit spending? While the US government as an entity might be able to cut its interest expenses, this will eventually be short-lived because the US government will be forced to issue more debt, and the interest expenses will quickly resume rising because the government will be forced to increase its deficit to support a weakening economy, not the opposite. This is exactly what happened to Japan for decades, and despite rates being held at zero, its debt has ballooned to 240% of its GDP today. Hey, but US tariffs will help improve the US deficit, no? This is a wrong assumption. Imagine US companies being willing to swallow that cost (because they are the ones paying for the tariffs), what’s going to happen to their profits? Of course, they will drop. And what happens to government taxes when profits drop? Of course, they will drop as well. What happens if companies decide to pass the US tariffs cost to consumers? Inflation will grow even higher, pushing a larger amount of the population into economic strain that the government will surely try to compensate with “stimmie cheques” and other forms of economic support, eventually impacting the government deficit.
An increase of overall monetary inflation will continue to inflate the stock market bubble that is acting as a magnet of liquidity, draining it out from productive economic use. This will detach stock valuations from the real economy even further, despite them already being at extreme levels. However, because of the law of diminishing returns, a bigger and bigger amount of money printing will be required to marginally inflate stocks. Clearly, the current policies are benefiting stocks against the real economy, and this will only worsen wealth inequality. This is the exact reason why Donald Trump won the popular vote by a landslide in the latest presidential election: people strongly voiced their deep discontent with the state of the economy, signaling they benefited little if anything from a buoyant stock market that is no longer a good yardstick to measure the performance of the underlying economy itself.
Against what everyone is pushing for, the FED should be raising rates instead and trigger a circuit breaker to force this whole messy situation to normalize:
- Deflating the stock bubble will divert resources back into the real economy
- Higher interest rates will force the government to rein in its out-of-control deficit spending
- Zombie companies will find it difficult to remain operational due to the higher cost of debt, and their demise will relieve the economy of their burden
- Inflation will be effectively tackled by increasing the purchasing power of the USD, increasing the overall wealth of the population
- A more fiscally responsible US government will attract demand again from foreign investors and strengthen USD’s status as a global reserve currency
Of course, the FED increasing rates will result in a great deal of pain in the short term, especially for financial markets, but that’s the price to pay after years of ill-guided policies in order to stop compounding problems into the future. Is anyone in power willing to face the blame for collapsing stocks and sending the economy into a “cleansing” recession without the assurance of being in power in the future when markets and the economy will resume growing healthily and organically and take credit for it? This happened only once with Paul Volcker at the FED and I fear it’s going to be hard to see it again in the foreseeable future, reason why things will be pushed to an extreme until they cannot withstand their own weight anymore and everything at that point will collapse with immense damages that cannot be postponed into the future any longer like it happened in 1929.
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