Fed Rate Cut: Is It Too Late? | Macro Alf

The Fed is late. The Fed is chasing. The Fed will do 50 basis point. Hold me accountable. We're recording one day before. Just joking. I mean, I'm I'm right about 53% of the times, might as well be wrong. Um, but I think they will do 50. They have to do 50 to catch up.

Welcome to Bankless, where today we explore the frontier of the Fed rate cut. And we ask the question Is all this too little, too late? This is Ryan Sean Adams. I'm here with David Hoffman, and we're here to help you become more bankless. Guys, at the time of recording, we don't know for sure how much Jerome Powell is going to cut rates. I mean, we are pretty certain he's gonna cut rates, right, David? He's gonna cut

Cut rates, right?

Oh my god. Imagine if he did. Assuming he he does, uh, then the question is how much will he cut rates? And shortly after this episode airs, you will know more than we do coming into this episode. But the question, regardless, on everyone's mind is what happens next? Are these rate cuts just in time, or are they too little too late? Will we get a recession or the soft landing that Powell and company are hoping for? And of course, what will happen to our crypto assets if all of these things come true? We discuss all of this with Macro Elf. He's one of our favorite minds in macro. We talk about why the Fed has been playing with fire, how it might cost us, and the coming era of money printing that's become pretty much the new normal.

I think many listeners like me are thinking that red Fed rate cuts are synonymous with bullishness. And I think while that is true, I think MacroL still kind of throws a flag at that and he says, whoa, whoa, whoa, not too fast. I think the the bullishness that comes from this rate cut cycle happens over like a longer time frame than I was I think uh people might be used to, uh, especially when like a lot of investors' minds are kind of primed with like the rate cut cycle of 2019 into COVID, uh flush with money printing. That's what that's what we think of when we think rate cuts, like we just flush the economy with money. Uh and MacRealph doesn't necessarily think that that is what the uh is the most likely outcome here. So he gives a little bit more of a nuanced take that this Fed rate cut cycle, while it is bullish, might not just be just super bullish for risk on assets. So uh I think if many um listeners have that expectation that they probably need to listen to this episode because that's what I what that's what I was going into this episode with. And uh I think he gave an alternative opinion, which I found useful. So let's go ahead and get right into this episode with Macro Alpha first a moment to talk about some of these fantastic sponsors that made this show possible. Bankless Nation, super excited to introduce you to Alfonso Pegatello, also known as Macro Elf. He's a macro economic analyst and an investment strategist. He's the founder and CEO of the Macro Compass, which is a fantastic educational resource for those who want to make sense of the macro world today. And he's going to help us make some sense of macro, especially right as things begin to change with the Fed. And first, welcome back to Banklets. We had you on over two years ago, and it was a fantastic episode. Really excited to have you back.

Long time no speak, very happy to be here. David, Ryan, hi, nice to see you guys.

So let's go ahead and uh get right into it. We are recording on September the 17th, right inside of the window where the Fed is expected to perhaps uh rate cut, cut their rates. Uh you uh Alfonso, you put out a piece on your Substack, a very fantastic Substack, which is titled This Is a True Regime Change. Uh, and one of your first sentences in there caught my eye. It says, The Fed is behind the curve and it's playing with fire. Uh, these are pretty big words. Can you unpack uh what you mean by this? What is the curve and why is the Fed behind it?

So the Federal Reserve main task is to cancel recessions.

Just joking. That's not their mandate, but that's what they're trying to achieve these days. These days, monetary policy is set to make sure there is a put out there, there is a floor under the economy, basically. And the formal mandate is inflation around 2% and a healthy labor market. The reality is there is always a trade-off between the two. And so at some point, the Federal Reserve set their policy only to fight inflation. But now that inflation has been moving down quite substantially, they realize that the labor market is showing cracks. And not only that, the overall economy is weakening. And so they run the risk of running behind the curve, which basically means you're late. You're not applying proactive policy, you're just chasing events and situations. And so if you think about it, what has happened over the last two years is that the Federal Reserve had one mandate stop inflation, stop inflation, stop inflation. And what they did is they brought real interest rate, so inflation adjusted interest rates, to very positive levels. So we had real Fed funds above 2% in positive territory, real interest rates above 2% for now 18 months and counting.

And this matters because for the private sector, real interest rates are very important. They're important for investors and they're important for people who have debt.

And actually, they play two different roles, right? If you have positive real interest rate, as a saver, as an investor, you're incentivized to put money in cash. I mean, you're rewarded a nice, positive real interest rate. So why would you do anything risky? You can just park your money in cash.

And if you think about it, this slows the investment activity going through the economy.

But that's even a bigger problem for people who have debt, for borrowers. Because now all of a sudden, instead of paying negative real interest rates, which is what people have been used to before the pandemic, and actually during the pandemic either.

Now, to sustain this growing amount of debt, you have to pay interest rates which are positive in real terms. So you're effectively facing a harder challenge as a borrower

while you're facing an easier challenge as an investor. So all that does is it slows the economy very aggressively because borrowing, the creation of new credit, gets slowed down aggressively because it's very expensive to do so. Look at mortgage applications, they are third year lows.

But on the other hand, as well, it slows down investment because people have a high reward on cash. So the Fed has brought these real interest rates at very positive levels.

And

effectively the economy held up for a couple of reasons we can discuss, but there is a point at which these relationships aren't linear anymore. They're convex. So basically,

this is not an economy, or the economic cycle in the fiat system is not linear. It can easily become convex and very fast. And I think now we're facing the situation where we might see these convex, lagged, negative events occurring ahead of us.

Is your message, Alf, that simply we've held interest rates at record high levels for simply too long? Uh I remember just one of the big learning lessons post-COVID when we were raising interest rates is that they raised interest rates too late. It was too late after inflation had already like had very strong indications of it being present. Uh and the Fed just took took forever to raise interest rates. And then they really had to play catch up. Uh, are we now just experiencing the other side of that where they're doing the same thing just on the other other leg?

I'm afraid so. So it's the behind the curve but inverted now because instead of being too too late in raising interest rates, they are now probably too late again, but in slashing interest rates. And so the risk back in 2022 was that inflation was going to pick up too fast because the Fed was too slow to react. And indeed it did. And now the risk is that the economy is going to slow down too fast because the Fed hasn't been proactive in cutting interest rates, but they've they've basically waited too long. And now these two risks are.

Quite interesting, I think, because effectively, if you have policy as tight as we have had it for the last 18 months, and just let's stop here for a second. People don't realize how tight monetary policy has been. Real interest rates at about 2% for 18 months in a row is a tighter policy than it was in 2006 and 2007.

So the Federal Reserve has held interest rates at tighter levels than before the great financial crisis.

Now, I'm not arguing we're gonna have another great financial crisis, but the level of policy restrictiveness is quite aggressive.

And has it happened as well is that in October 2007, the IMF and the Federal Reserve held projections for GDP growth for two thousand and eight.

And they were projecting the US economy to grow at 2% in 2008. Well, I remember something else happened. But I'm mentioning this to you because effectively you grow, because the lags can be very long between applying monetary policy and seeing the results of monetary policy. There is a point, somewhere like 12, 15 months down the road, where people become very convinced that this time is different, that policy isn't tight, that the economy isn't going to slow down. And this tends to happen, funnily enough, generally speaking, very close to periods where the lags are about to really kick in. Like it happened in October 2007, and a few months later, we had a big problem. In summer this year, if you remember, everyone, their mothers, their dogs, anyone was talking about a soft lending. It was a done deal. It's done. Like there is no discussion. The US economy can handle 5% interest rates forever. The Federal Reserve was priced to cut rates never, pretty much, only a few cuts. We didn't need anything anymore. And now the job market is becoming to soften pretty aggressively, and people are starting to worry. And I think that look, the reality is that you have held policy at very tight levels. So with the lag, you are going to see issues here. And we can talk about how long is the lag because it is quite long this time, this time for certain reasons. But the fact that lags are long doesn't mean that monetary policy legs do not exist anymore.

All right, so your message, Alf, is that uh Powell has been flying far too close to the sun here. He should have taken some action many months ago. I don't know what your time span is for that, but ca can I ask you the the question that's in the back of my mind is if if this is such a tight policy and has been uh like uh almost like historically tight. I mean, I guess we've seen other times in in history. You mentioned 2007 uh as like you know such a time, but uh how come things haven't broken yet?

That's an excellent question, Ryan.

So I think the lags are very long this time for a few reasons. Okay. So why is that normally you raise interest rates and an economy slows down? Let's talk about the basics here. Okay.

You raise interest rates, and what happens is that the borrowers, so in our world, households applying for mortgages and corporates that are using leverage and loans and bonds to finance their activities, well, both of them are going to slow down, right? Because you're making borrowing more expensive.

So they're going to start borrowing less, okay? And as they borrow less, they're also going to be starting to spend a little bit less, right? They they can lever their balance sheet less. Therefore, they're going to be cutting some discretionary spending, marketing and stuff like that. And then at some point, they will realize that cutting discretionary spending only is not really a strategy if those interest rates are high for long. So they need a plan, which is more long-term, okay? So they're going to start looking at trimming their more core costs. For example, labor. Okay. They're going to take and they're going to cut off their temporary workers. If you look at temporary workers' layoffs, for example, these are it's one of the best leading indicators for the job market exactly for this reason, because companies tend to trim first, you know, the fat around and then they move closer and closer to their core costs. Now you do this exercise for long, and at some point you have to cut your workers. And also you will have households that are not applying for mortgages anymore, which means the entire real estate market, housing market, and anything ancillary will also slow down. And that represents 10 to 15% of GDP. Okay, so you have less mortgages, which means you have less renovations, you have less building, you have less anything, right? And this is the mechanism by which slowly but surely you'll have corporates slowing down their hiring, people are gonna get hired less, which means they're gonna be less prone to spending, and therefore the economy slowly but surely declines. And then on the other hand, you're gonna have households. And if households have to refinance their debt at higher interest rates, they also will think like, Holy crap, I am making $4K a month or whatever, $4,000 a month. But now my mortgage instalment is going up because interest rates have been increased, and therefore they're gonna be spending less. Okay, so this is generally the circle that slows down the economy. But let's discuss about what happens this time, okay?

Because

I talked about mortgage refinancing

and you look at the data, and something like over 90% of US mortgages are 30-year fixed.

So when the Federal Reserve increases their interest rates and the new mortgage rates are 7%, right? You immediately think like, holy crap, man, I mean, who's gonna apply for a mortgage? And instead, no one is gonna apply for a mortgage. Indeed, that's correct. Nobody is applying for a mortgage. But that doesn't really slow down consumer spending unless you can pass through these high rates to existing mortgage owners, to existing homeowners. And well, these guys aren't feeling it. They locked in mortgages at 3%, 4%, 4.5%.

And they're not getting the pass-through because they're not variable rate mortgages. They're fixed mortgages. Long-term fixed mortgages do not suffer immediately from an increase in interest rates, do they?

Contrary to 2006-2007, when a lot of these mortgages were variable. And so a variable mortgage means that when the interest rate is getting hiked by when you get a Fed hike, basically, you immediately feel it. This month you feel it already on mortgage instalment. This time, it isn't the case. What about corporates? Same story. Look at Apple, look at Microsoft, look at also the biggest companies. They were very smart. In the period preceding the pandemic, 2019, but also 2020 and 2021, they took the opportunity to lengthen.

their debt obligation. So they went there and Apple issued 30-year bonds, for example. Same story. They behaved like households and they said, well, you want me to borrow for the next 30 years at 2%?

Sure, I'll take it. So they lock their liabilities, which means again, the Fed increases interest rates, but corporates are flush with cash and they don't care. They don't feel that pass through, right? Of higher interest rates immediately.

So you have this situation.

This is lengthening the legs. It means that for interest rates to pass through to the economy, it just takes longer and longer. And on top of it, on top of it, you have fiscal.

Because what has happened is that Biden has done basically a big round of fiscal in 2023 that basically offset some of the monetary policy tightening. So not only the pass through of interest rates was low.

But on top of it, the government went in 2023 and said, Yeah, you know, guys, here is two trillion dollars of fiscal deficit. You know, just take it. And and corporates got, you know, uh the good positive tailwinds and households as well. They got tax cuts, they got good income coming in. When the government does fiscal deficits, the private sector enjoys it. It's basically a slash of taxes, it's incentives, it's money lending on the bank account of households and corporates.

There is a fantastic chart from the IMF

that shows the pace of interest rate hikes, and this times me like 500 basis points vis a vis

the change in net wealth of households and corporates. And you would expect, and you can see that in the past, in every episode when the Fed hiked interest rates, well, the net wealth of the private sector goes down, right? I mean, they take a hit effectively because they have to pay more on that servicing costs.

This time, the Fed hiked 500 basis points, the net wealth of households and corporates went up.

This is the first time in history. The combination of fiscal and these very long legs that are due to the structure of the credit system in the US, which is long-term fixed rather than short-term variable, has made it so that it actually is taking a lot of time for these hikes to feed in. To the point where people said, well, this time is different. The hikes don't count anymore. It's over, the US economy can handle it, forget about it. It's a new era. In reality, it's not a new era, it's the same old era. It just takes a lot longer, and we need to respect these lags and understand them.

Yeah, it's interesting how maybe the fed Fed tools aren't working the way they think that um they are working. And and so you're sort of describing this um this kinetic energy potential. It's almost like a wave that's building in the distance, kind of like a tidal wave, but you know, it hasn't yet reached us, and we can sort of maybe maybe see it miles off the coast and it's it's coming our way. I I don't know if um in your post you use the word recession or not, but the regime change that you're talking about, where you're talking about the Fed playing with with um fire, and this will result in a macro regime change. Uh, you summarize it this way, which and I want to understand what you mean by this, Elf. Bad news in this new regime, bad news is actually bad news.

Okay. What does that feel like when bad news is bad news? What regime have we been in? Are we just able, you know, uh currently and in in the past uh couple of years, able to shake off the bad news? And uh in this regime change, now when bad news hits us, it will actually feel like bad news. Describe that. And is that essentially a recession? Is that what you're describing?

So do you guys remember actually when before the pandemic you had to maybe a slightly weak number on the growth front, like a low GDP number or a weak labor market report and the stock market rallied?

Can you remember that? Because it happened all the time. You know, effectively you had bad news in the economy, and the stock market was like, Yeah, sure, that's great. I'm gonna rally now. And you're like, what the hell is going on here? Well, it wasn't.

Like inverted. It would imply that just like we're gonna rain more money.

Yeah. And so there the thought process was, well, we are far from recessionary levels. Like the economy isn't so weak, it's just weak, right? And so we are far from that uh danger level. And on top of it, we have the Fed having our back. We have the so-called Fed put. Okay. Basically, there is the Federal Reserve that says, hello guys, every time we're gonna have a minor slowdown in economic growth, we are here, we have your back. Don't worry, we have a put here. We're not gonna allow the market to sell off more. Okay. So people have lived through that last decade, especially basically between 2013 and 2019, knowing that bad news is good news for markets, right? And I'm now saying that bad news is actually bad news again. And there are two reasons why I'm saying that. So the first one is

Look, when you get closer to that recessionary risk,

you don't have any more so much margin.

margin for error, I mean. So when the economy weakens from an already weak level like it is today, and the US is not even able to create a hundred thousand jobs a month, like where we are today is that the private sector in the US is creating about a hundred thousand jobs a month. They might seem a lot

But the US has an increase in labor supply of about 120, 130,000 jobs a month. So what it means is that the US must create every month about 120 to 130,000 jobs just to break even, just for unemployment rate not to explode higher. We have a big net immigration in the United States, it's increasing. That means there are more people entering the economy, more people eligible to work. You gotta put them to work. And so the break even has now increased to about 120,000 jobs a month. So anything below that, well, the margin for error until you see unemployment rate spiking higher and you go into a recession is not very high. So the closer you get to that, you know, to that convexity point, actually, to the point where

from weak growth you start having recessionary vibes, the more bad news is actually bad news. So now every time you see a bad economic print, you also see the stock market selling off. And that's something strange. That's something people aren't used to any more, and that's something important to understand.

When was the last time we felt like this? Like when was the la like last regime in in investors' memory? Like bad news being bad news?