Just two words uttered by Fed Chairman Jerome Powell during a mid-day speech on Wednesday, November 28 sent the S&P up 2.3% by the close. The S&P 500 went on to notch an overall 2.8% gain for the week—despite lingering uncertainty surrounding the G-20 Saturday, December 1 dinner meeting between Presidents Donald Trump and Xi Jinping on the ever-mercurial Sino-American trade war.
Powell’s words—“just below”—referred to the proximity of the Fed funds rate to the Fed’s self-determined “neutral rate.” Those words were welcomed with relief by investors. The Fed’s prescriptive porridge was neither too hot nor too cold at 2.50%, which assumes a .25% increase this month. And yet, as recently as October 3, in an unscripted answer to a question about how high the Fed may have to raise the rate, Powell said, “We may go past neutral…but we’re a long way from neutral at this point, probably.” To be fair-minded, Powell did acknowledge that “interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy—that is, neither speeding up nor slowing down growth.”
To offer some context for readers, the average neutral rate (which is actually a range, currently between 2.5% and 3.5%) has fluctuated within 100 basis points below the prevailing trend in nominal GDP. The current nominal GDP run rate is (a) about 5.5%, (b) currently bolstered by the fiscal stimulus, and (c) likely to slow next year.
As a not insignificant aside, Chairman Powell’s already daunting job is complicated by the rantings of Mr. Trump, who has insisted loudly and repeatedly that the Fed should be held responsible for any weakness in the U.S. economy. In a Washington Post interview, the day before Powell’s speech, the president said the Fed was a “much bigger problem than China.” Relentless, he continued: “I’m not being accommodated by the Fed…I’m not happy with the Fed. They’re making a mistake because I have a gut, and my gut tells me more sometimes than anybody else’s brain can ever tell me.” Regardless of one’s political persuasion—and anatomical predilections—there should be little disagreement that with ill-informed antagonists like Trump, Powell is in no need of enemies.
So, if not intimidated by the president, why did the Fed hit the pause button? After all, Powell was forecasting continued solid growth[i] and said the “financial system is much stronger, and financial institutions and markets are substantially more resilient than before the crisis.” Moreover (although he has seen no evidence so far), “large, sustained declines in equity prices can put downward pressure on spending and confidence.” If they do, he promised to act. For hypothetical levels for intervention, see the recent post by Eric Cinnamond. Long live the Greenspan put.
As the chart below indicates, the Fed’s pause highlights a conundrum—a warning that seemingly no one wants to hear. Of course, the pause could be thought of as one offering binary choices: It could be followed by a resumption of the hikes—or the opposite. As an example of the former, examine the pause in 1998–99 (orange circle). The resumption of hikes through 2000 coincided with the market’s peak. Although the market experienced sharp rallies immediately following most rate cuts during the period from 2001–2004, the overall trend was downward.
Moving on to the next credit cycle…After the Fed funds rate steadily rose beginning in 2004, a growing awareness of the impending housing crisis caused the central bank to hit the pause button for 14 months beginning in 2006, coincident with the rolling top of the equity market. The recession began in December 2007. Each time the Fed cut the benchmark rate thereafter (most notably during the darkest days of the financial crisis), the markets rallied violently, but temporarily, only to soon resume the decline.
Has the Fed bought speculators a little more time? If the economy continues its current growth well into 2019, the answer may well be yes, as the economy will have more time to adjust to higher rates. But the Fed faces a Sophie’s choice. If inflation would get ahead of it, any response harbors significant negative consequences. Inaction, however, would likely mean stagflation lies in waiting. Alternatively, if the Fed attempts to tamp down growing inflation expectations by cooling the economy now, the risk of recession and its myriad financial side effects increases. This would likely throw the capital markets into a tizzy if not a tailspin. Here is the heart of the conundrum the Fed faces.
Powell, not shirking his duty, did identify two areas of systemic risk in last week’s speech. The first was debt. The ratio of corporate debt to GDP is well above its trend, and firms with already high leverage and interest burdens have been those most aggressively increasing their debt loads. While Powell acknowledges the fragility this situation poses, he doesn’t believe that business bankruptcies and the unwinding of collateralized loan obligations (CLO) will undermine the financial system or significantly impact the broader economy. Second, he discussed the high valuation of equities relative to history. He doesn’t see that risk as excessive, however. Disconcertingly, that “not to worry” mindset was the hallmark of predecessors Bernanke and Yellen, which alone might be reason enough to worry.
Mixed Economic Signals at Home…
Unfortunately, the economy is not a compact disk, for which pauses have immediate effects. Any Fed action takes time to alter the economy’s inertia. Such is the case for a pause in rate hikes. Unlike markets, economic direction is not immediately responsive to changes in interest rates.
As we have stated in earlier posts, certain leading indicators are flashing yellow. Since the first week of October, crude oil has plummeted from $76.50 to $52. The decline cannot be wholly attributed to excess supply but seems to be indicating something about the global economy. While U.S. unemployment remains near-record-lows, it is a contrary indicator. Tight labor pushes up wages and business costs. According to the Atlanta Fed, the three-month moving average for median wage growth reached 3.7% in October. This usually causes the Fed to increase the cost of money, which it has been doing incrementally since December 2015. The lag in economic data, however, makes it difficult to access the relationship of real inflation to the target the Fed would like to hit.
We can a more granular picture by looking at the business level. For instance, the RV industry has seen rising costs from labor shortages for some time. The higher hourly rate would indicate a hot economy that, if generally the case nationwide, may require further tightening to avoid inflation. Reported wages, though, are only half the story. In the RV industry, unplanned shutdowns and four-day work weeks are currently restricting present incomes. When such situations might show up in official wage or inflation data is some time down the road.
…and Abroad
While the U.S. data gives pause, on the larger stage, the OECD (Organisation for Economic Co-operation and Development) says “global economic growth has peaked.” The rise of protectionism and related trade conflicts are among the culprits. Even the mechanisms for conflict resolution have suffered. Canada’s Prime Minister Justin Trudeau hinted that the G-20’s role has evolved from a forum for consensus building into something closer to “bilateral speed dating.” Breaking news over the weekend that the pause button in the Trump-Xi trade war has also been hit with a 90-day cease-fire was greeted this Monday morning by the futures market with a sea of green. The preopening S&P futures were up 1.75%.
Could this be another example of “the triumph of hope over experience”? Some openly worry that the escalating tensions between the U.S. and China are more than negotiation tactics but are instead a modern-day version of Thucydides’ trap—a broader contest for supremacy on the global stage.[ii] In this age of twitter diplomacy, separating the signal from the noise is nearly impossible.
Beyond unmistakable growing global acrimony—and echoing a similar lament found in our posts—the OECD is dismayed that the economic recovery is being supported by low interest rates and easy credit while investment and productivity growth have remained largely stagnant. Productivity I. Productivity II.
As for the U.S. market, the upward momentum dating back to 2009 has, at the very least, encountered a speedbump. Since fundamentals long ago ceased to matter, sometimes we find it painfully necessary to gather clues from the market itself. Before the week is out, the 50-day moving average will drop through the 200-day moving average, creating a “death cross.” The death-cross indicator has proven an accurate predictor of the most severe bear markets of the past century: 1929, 1938, 1974 and 2008. When a death cross occurs after a 10% correction, however, it often signals a buy-on-dips opportunity, albeit temporarily. There are, after all, few certainties in the capital markets.
Longer term, though, should the 200-day moving average line (200ma) decline by more than 3%—a mathematical improbability in the near future—the likelihood that we will already be in a bear market is high. Only once in the last 50 years (the 2015/2016 corrections) did such a decline fail to produce a bear market, and the conditions then were not comparable to today. Unlike then, or the major moves in 2000 and 2008, the market has risen so far above the 200ma that a significant downturn may only come after the bear market has been established.
Given this combination of macro signals and market technicals, the Fed surely has an unenviable task. The discomfiting truth is that the ultimate direction of markets may in the end be largely uncorrelated with its actions.
[i] Q3 GDP growth, second estimate, 3.5%. Trump seems obsessed with reducing trade deficits as a pillar of his economic policy, and yet net exports made their largest negative contribution to GDP since 1984. You can’t make this stuff up!
[ii] Allison, Graham. Can America and China Escape Thucydides’s Trap? When a new superpower threatens to displace a ruling power, the clash of hubris and paranoia often, but not always, results in war.