The Fed lowered interest rates 25-basis points on Wednesday as advertised. In the subsequent press conference, Jerome Powell confused everyone about the FOMC’s future course and stocks fell by over 1%. Then yesterday, as the yield on 10-year Treasuries fell to 1.95%, stocks started to take off once again until President Trump threatened more tariffs against China. Low rates mean higher P/Es which mean higher stock prices, tariff fears aside.
A lot of market pundits point to 1987, 1995 and 1998 as examples of when the Fed cut rates during relatively good times to maintain and extend an economic expansion.
Let’s look at each.
In 1987, the stock market soared and bond prices cratered steadily until the end of August when air started to leak out of the bubble. Then one Monday in late October, it burst completely as the Dow fell 22% in one day. These were days before complete automation. You actually had to call an order desk to execute an OTC order. By Tuesday morning phones were ringing off the hook and no one answered. The Fed stepped in and provided liquidity, including lowered rates. It was a brief but bold reaction to a sudden event. A year later, most of the losses had been recouped and markets continued on their merry way. There is virtually no correlation to today’s market. Yields today are low and headed lower. There is no panic in the equity markets. So, let’s move on.
1995 is a better example. After several years of a strong economy and solid stock market, interest rates started to spike. Bond investors were getting killed. The stock market fell, but most of the damage was in the bond market. The Fed stepped in to lower rates and try and bring calm to markets. It worked. The recovery resumed and the stock market went on to enjoy 4+ years of extended gains. Once again, however, we are comparing a reaction to higher rates and increases in inflation expectations to today’s world where inflation expectations have been consistently anchored at or slightly below 2% for some time. Thus, let’s move on once more.
In 1998, the economy was performing fairly well, consistent with growth levels we see today. The stock market was becoming ever more bifurcated. Everything tech and Internet-related was hot. The big cap darlings were Microsoft#, Intel, and Cisco. It was also a time of one-decision stocks with the big cap drugs, GE and P&G# leading the parade. IPOs connected to anything Internet soared. Smokestack America was to be avoided at all costs. Leaders sold for 10-12 times earnings. Second grade companies sold for less. Valuations were starting to get stretched. After a 20% correction, the Fed tapped the accelerator a bit, lowered rates some, and extended the bull market and the Internet bubble for another 18 months or so. In the spring of 2000, however, it finally burst and there was not much the Fed could do to stop a 40% bear market and a post-9/11 recession.
If this market resembles any of the above, it is 1998. But let’s look at the picture from a different viewpoint. The Fed is charged with maintaining price stability (which it equates with keeping inflation near 2%) and providing an interest rate framework that can foster growth. Some argue that the Fed tapped the brakes too hard last year with four rate increases slowing growth from 4% to 2%. One can argue that tariffs had at least something to do with that slowdown. Inflation remains missing in action. Too much supply means low prices. Recent GDP numbers show a decline in capital spending. That is what you get when supply is too big. Commodity prices are weak, another sign of excess supply. Natural gas prices are less than half of what they were last fall despite the fact that producers are flaring gas because of a lack of pipeline capacity.
There is not just an oversupply of goods and manufacturing capacity; there is also too much money. Central banks around the world, largely meaning the ECB and Bank of Japan, face lower growth mostly due to bad fiscal policy, excessive regulation, and horrible demographic trends. Their response was to lower central bank rates to zero and flood the system with money.
The world’s problems today aren’t too little money; it’s too much capacity.
If you have a house with three kids and you already have 5 gallons of milk in the refrigerator, are you going to buy more milk even if it’s $1 off?
Negative interest rates don’t create more spending; they create more confusion. They chase money overseas. They create hoarding. They don’t increase capex. Yes, they do move money into stock markets and other financial assets that benefit from lower rates but what comes next? Even more negative rates?
Our Fed watches what is happening overseas and has decided they can’t keep rates at 2%+ while the rest of the world is at zero or below. Instead it chose to chase bad policy! Inflation readings have actually been rising in recent months in the U.S. That’s before another possible round of tariffs, a tax that will be passed on, at least in part, to consumers. The rate cuts weren’t needed to tweak inflation expectations. Growth is 2%+. They weren’t needed to increase growth either. Thus, they don’t fit existing mandates but, rather, a new set of guidelines the Fed has decided to create. No wonder markets are confused.
The Fed gave in to markets that love lower rates because, at least in the short run, lower rates mean higher asset prices. I hope they didn’t give in to President Trump’s rants, but his constant criticism can’t be 100% ignored.
What happens from here? If rates keep going lower at both ends of the curve, more cuts will follow. I don’t think we are headed to zero. Negative rates around the world won’t last forever. When they revert to normal (which is something higher than the rate of inflation), asset values will subsequently fall. I am not advocating selling any financial assets today. As long as central banks want to ignite further gains by lowering rates, you don’t fight the Fed. But what the Fed and other central banks are doing today will bring the end point closer, not extend it out several years. Enjoy it now but realize that low rates carry a price long term. So does an accelerated buildup of sovereign debt.
President Trump wants lower rates, massive increases in spending and higher tariffs. He believes he can engineer an economy that will peak before next November’s election. Time will test his economic skill. His move yesterday threatening additional tariffs, if implemented, certainly won’t help. They won’t accelerate growth, but they will lower trade volumes, increase prices and lower corporate profits. Perhaps he hopes to pull the tariffs back next year in front of elections, but he needs a robust deal with China to make that work to his benefit. China, meanwhile has a choice of retaliating, giving in, or waiting Trump out until after next year’s elections. I will leave the choice of outcomes to political scientists but none of the options, short of a robust deal, look all that appealing to me.
Today, actress Mary Louise Parker is 55.
James M. Meyer, CFA 610-260-2220