The financial markets have cast their vote for a 50-basis-point interest rate cut. In the days leading up to the Federal Reserve's two-day meeting that began Tuesday, Fed officials were trying to talk expectations down. They've been telling anyone who will listen that a 25-basis-point cut is still a real possibility. Whatever the Federal Open Market Committee does Wednesday, however, all of us -- Fed policymakers, CEOs, retirees, investors and consumers -- are about to begin a journey into uncharted economic and monetary territory. Let's hope it doesn't get too exciting. If the Fed cuts the federal funds rate -- now at 1.25% -- to 1% or 0.75% with a cut of 25 or 50 basis points, the real rate would be deeply negative. With core inflation running at 1.6% annually, the real federal funds rate could be a negative 0.85. Money market accounts, which currently pay just 1.35% on average (a negative return when inflation is factored in), are likely to drop even more into the red. The three-month Treasury bill is already paying just 0.8% in anticipation of the Fed's move. The Fed's stated goal is to provide enough liquidity at a low-enough price to get the economy rolling again at something above the 1.9% growth in U.S. gross domestic product recorded for the first quarter of 2003. But no one knows what kind of unintended consequences cutting interest rates to 1% or less will have as the rate cuts ripple through the global economic and monetary systems. Let's look at five areas where the unintended effects are largely unknown but could be huge.
Will Money Market Funds 'Break the Buck'?I doubt it. Investors have come to believe that no matter how low the yields in a money market mutual fund go, the safety of their principal is guaranteed. Any fund that allows the price of shares purchased for a dollar to fall below a dollar risks extinction.
But preserving that price is an increasing strain on mutual fund companies. Even though these funds are now paying almost nothing in interest to their investors, they also earn almost nothing themselves on their own short-term investments. For example, the Schwab Money Market Fund shows a portfolio with an average maturity of 60 days. Money market funds have to be invested in this kind of short-term paper, because investors can withdraw money at any time. Yields on this kind of investment, though, are often already below 1%. Commercial paper directly placed by GE Capital yields just 0.95% on maturities of 46 to 77 days. Schwab charges investors 0.79% in operating expenses on this money market fund. No wonder the Schwab Money Market Fund is paying just 0.51%. But those numbers show the squeeze that's ahead if the Fed sends short-term rates much lower. Either Charles Schwab ( SCH) will have to cut the yield on the fund, making it harder to attract investors, or it will have to cut its expense ratio. That's not exactly an easy choice when Schwab has $121 billion in money fund assets.
Will Income Investors Pile On More Risk?It's a likely scenario, because income investors are already headed in that direction. Martin Fridson, the former junk bond analyst at Merrill Lynch ( MER) who now publishes the weekly LeverageWorld, calculates that junk bonds are now more overvalued than they've been since September 1986. Part of the reason is that everyone is searching for yield. So far in 2003, $20 billion has flowed into junk bond mutual funds, making 2003 the second-best year for these funds on record even though we're only in June. Investors are getting much higher yields from these junk bonds than from money markets or Treasuries, to be sure, but while the spread is large, the absolute yield seems low, given the risk investors are taking on.
Xerox ( XRX), for example, just issued $700 million of seven-year notes paying 7.13% and $550 million of 10-year notes paying 7.63%. Certainly this financing improves liquidity at Xerox, but this is still a company fighting for its life. That 7.63% yield will look great if nothing goes wrong with the economy (and interest rates don't rise) by 2013, but it isn't a lot to collect for the risk that investors in these bonds are taking on.
Will Another Cut Finally Kill the Bond Rally?Yes, if investors believe this is as low as rates will go. Bond yields have been terrible in 2003, but total returns on bonds have been above the historical annual average of 5.3% for long-term government bonds. The ( VBLTX) Vanguard Long-Term Bond Index , for example, has returned 9.6% so far in 2003. But much of that total return has been from capital appreciation as bond prices rose thanks to the Federal Reserve's interest rate cuts while yields fell. If that drop in interest rates is over, returns from bonds and bond funds will gradually converge on their actual yields. The Vanguard Long-Term Bond Index currently yields 5.07%, not bad, but half the total return for the year to date. Logically, bond prices should stop rising because we're clearly at the end of the interest rate cuts. But there's another factor at work here: Foreign central banks are buying U.S. bonds, especially U.S. Treasuries, as a way to prop up the dollar against their own currencies. Jim Grant of Grant's Interest Rate Observer reports that foreign central bank holdings of Treasuries are up 22% in the past year. That's a lot of buying that could keep bond prices ticking upward, even if the Federal Reserve has left the rate-cutting game.
Will Another Cut Push More Investors Into Stocks?You bet. That's exactly what the Fed seems to intend. Propping up and extending the housing boom created a positive wealth effect that helped consumers keep on spending, even though they'd suffered huge hits to their wealth in the stock market.
Adding a little more fuel to equity prices will give consumer confidence another boost as investors start seeing black ink on their quarterly financial statements. And increasing equity prices will help corporations trade equity for debt on their balance sheets, improving corporate profits and providing cheap money again for investment in capital equipment. At least that's the way the story is supposed to go. Apologies to Mae West, but too much of a good thing isn't always wonderful. The potential unintended consequence in this case would be to reinflate the bubble in financial assets before it has fully finished deflating from its maximum expansion in 2000. If corporate spending on real assets doesn't pick up, the liquidity that the Fed is adding to the economy, plus its nudge to move investors from bonds to stocks, could send stock prices climbing again without support from improving economic fundamentals. The danger here is that with capacity utilization about 74% in May, corporations won't see a need to increase capital spending. And that will leave a lot of dollars chasing financial assets.
But those partners, especially the ones that have built their economies around exports, can't afford to see their products priced out of the U.S. market. So they sell yen or Deutsche marks and buy dollar-denominated assets such as Treasury notes to strengthen the dollar against their own currencies. How long can these foreign central banks keep this up? As long as they've got ink and paper to print more money. And as long as the political winds say that the risk of future inflation is more than offset by the rewards of current employment. U.S. exports should get a modest boost, but the dollar probably won't sink too much further from current levels. These are just the possible unintended consequences from a conventional interest rate cut of 25 to 50 basis points. Be prepared.