A Fed Rate Cut Is A Sign We Should All Buckle Down And Be Careful

A Fed Rate Cut Is The Signal We've All Been Waiting For To Buckle Down

The Federal Reserve’s decision to cut the federal funds rate on July 31, 2019, signifies several things:

1) The Fed screwed up in December 2018 by hiking rates for the 9th time in three years. Cutting rates just 7.5 months after hiking rates is like getting a divorce within a year. The signs were everywhere, but the couple simply chose not to look because they were too horny.

2) The Treasury bond market is a better indicator of the economy’s health and dictates the proper interest rate policy, not the Fed. All year and parts of last year, the yield curve has been flat or inverted, telling the Fed it needed to cut rates as growth slowed. The Fed finally relented.

3) The Federal Open Market Committee members may have PhDs and plenty of financial experience, but they are often guessing at the best course of action just like the rest of us. Do not treat their word as God. Do not underestimate your own abilities to make money either. Relying on someone else to make you rich is suboptimal.

4) We should all be on high alert for an impending recession within the next 12-18 months. The more the Fed cuts, especially when rates are already so low, the more we should worry.

 

Recessions Always Follow Euphoria

Due to my experience working through the 2000 dotcom bubble and the 2008 housing bubble, I’ve learned that the greatest downturns tend to happen right after the most euphoric of times.

1999 was especially awesome because you could buy practically any internet stock and double your money within a few short months.

The Market Cycle In Emojis

It is clear to me we are currently in the Euphoria/Complacency stage. How long we last in this stage is hard to know.

We’ve been in a bull market since 2009 and the majority of us are the richest we’ve ever been. As a result, it’s understandable to be punch drunk with financial happiness.

The median age in America is 38, which means that about half of the U.S. population has never significantly lost money in the stock market or real estate market.

When so many of us feel like we can’t lose, we can often lose the most.

Late cycle indicators include:

  • The rise of the Financial Independence Retire Early Movement. I’ve been writing about FIRE since 2009 with zero fanfare until circa 2017. Now you can’t go a day without reading or watching an early retirement story.
  • The rise in remote work and freelance work. Going to work in an old stuffy office is so passé. According to the Freelancers Union (yes, there is such a thing), by 2027, more than 50% of American workers will be freelancers vs. ~40% currently.
  • The return of zero money down purchases for homes. To compete for more business, lenders are rapidly lowering their standards just like they did before the housing bust.
  • The explosion in credit growth despite credit card interest rates reaching 5-year highs. Consumer confidence is so high that they don’t mind paying usurious rates.
Historical Consumer Confidence Index
  • Insiders from companies like Beyond Meat cash out to retail investors through a secondary offering after shares have soared.

When 23-year-olds making $30,000 a year tell me they have no problem retiring early because within 20 years they’ll have amassed a $2,000,000 net worth by eating at Applebee’s every day, never spending any income on fun, and earning a 12%+ compounded return, you know we are at max euphoria.

I have many more examples of illogical and delirious types of thinking. However, if I listed them all, you’ll start thinking I’m a meanie with no heart. In this day and age of super sensitivity, this would be a dangerous road to take.

Instead, you’ll just have to search the internet for stories about people who think they’re going to live the good life on a small financial nest egg with nothing ever bad happening to them.

A Fed Rate Cut Always Proceeds A Recession

You may not accept any of my late-cycle indicators or believe my stories about euphoric people who think they just can’t lose. That’s fine. I can only share with you my personal experiences and the feedback I get from the over one million people who come to this site each month.

For the unbelievers, let’s just look at the data from my favorite recession indicator chart. The chart below is from the Fed itself.

The blue line is the historical effective federal funds rate. The shaded gray lines indicate a recession. The red arrows that I’ve unartistically drawn emphasize the correlation between the Fed rate cuts and a recession.

Effective Fed Funds Rate And Recessions That Follow

Notice a pattern? As you can clearly see from this unbiased chart, a recession almost always follows within 12 months after the Fed starts to cut rates.

It’s important to understand that a recession does not occur because the Fed has cut rates. A recession follows because of the normal boom-bust cycle of the economy. The Fed is only making reactionary moves to try and prevent a recession because it is unable to predict accurately an economic cycle.

The classic boom-bust cycle can be illustrated by the housing market. The time-lapse between when developers first realize and then meet soaring demand for housing may be years because it takes time to build new apartment buildings and single-family homes. As more and more supply floods the market, prices fall.

The key is to have a large enough balance sheet to build and invest counter-cyclically, not at record high prices.

Market Quadrants Cycle

When it comes to the timeliness of rate increases or decreases, the Fed is perpetually behind. We saw an example of this inefficiency with the rate hike in December 2018 followed by the cut in July 2019. If the Fed was more efficient, the effective fed funds rate would be much less volatile and there would be no recessions.

The Fed certainly has more economic data at its fingertips than the average person. But even if the Fed foresees a dramatic slowdown in the future, it cannot transparently say so for fear of spooking the market. Thus, oftentimes the seeming lack of clarity in its statements. The Fed rightly fears that whatever it telegraphs will become a self-fulfilling prophecy and render its policy ineffective.

Therefore, a smart Federal Reserve Chairman will learn to speak for hours without saying anything meaningful. Ex-Fed Chairman Alan Greenspan was famous for talking gibberish. He successfully pawned off the bubble he helped build to Ben Bernanke on January 31, 2006.

If the Fed can continue to speak more gibberish and only cut rates this one time, the Euphoria/Complacency stage will likely continue. Borrowing costs are lower and the Fed is signaling the economy is strong enough not to warrant further cuts.

But if the Fed starts to cut interest rates more than two times and in larger increments, then a recession will most likely hit and the S&P 500 will most likely decline months from now.

Stock market performance after a rate cut
Source: Dow Jones Market Data, Federal Reserve

Anecdotes Plus Data Likely Equal Reality

The key to reaching and maintaining financial independence is to avoid blowups. The blowups are what ruin lives because they not only rob you of money but of precious time.

You cannot afford a financial blowup if you are retired, within five years of retirement, have dependents, have a disability which may reduce your ability to work for longer than a potential recover, don’t have enough passive income to cover your basic living expenses, or are delusional.

If you’re still within the first 10 years of your financial journey, are able to eat at Applebee’s every day, and never plan to have kids or take care of family or friends, feel free to take as much risk as you want. It’s all about you baby!

For regular folks, I suggest being much more cautious at this stage in the cycle.

Please do not have revolving credit card debt, ever. Pay cash or don’t buy it at all. The average credit card interest rate of 18% is highway robbery.

Please don’t be tempted into buying a new car either because your car loan interest rate is now a measly 0.25% lower either. Paying much more than 1/10th of your gross income for a car is truly one of the worst purchases you can ever make. Drive your beater for a while longer.

Do refinance your mortgage if you can break even within 24 months and plan to own your home for years after. Fixing your living costs is one of the best financial moves you will ever make. An inverted yield curve is like borrowing free long term money.

Do save aggressively with banks that pay a higher interest rate than the current 10-year bond yield. Such an arbitrage opportunity is rare and should be exploited. If the markets tank but you’re earning a risk-free 2.3%, you’ll feel splendid.

Don’t be so naive as to wish a financial crisis on the world so you can “buy assets for cheap.” Assets valuations are a reflection of their projected cash flow. A stock is not cheap if its price halves and its earnings decline by 90% for the next couple of years. In fact, the stock has gotten more expensive. Besides, you might not even have a job that will give you the guts to buy “on the cheap.”

Most of all, learn to enjoy your life regardless of where we are in the cycle. If you’re on top of your finances, then you should be fine no matter what happens. It’s only those people who have risk exposure incongruent with their risk tolerance who lose big.

Don’t be like those people.

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