Stocks finished mixed yesterday, a day when the yield curve briefly inverted once again. More about that in a moment. Traders were anxiously awaiting Fed Chair Jerome Powell’s speech this morning that may help to clarify the Fed’s near term and long term strategy.
Yesterday’s yield curve inversion was very different than the one last week. But first the similarity. Both were extraordinarily brief; just a few minutes. And both were microscopic. The inversion was less than a single basis point. But last week’s inversion that led to a 3% market drop was caused by a plunge in interest rates. As it happened, the long rates fell faster than short rates causing a brief inversion. Yesterday’s action was the exact opposite. Rates rose across the board but short rates (i.e. 2-year Treasuries) rose a bit faster than long rates. Even after the inversion, something many traders say signal an impending recession, rates continued to rise all along the curve. Logically, higher rates mean economic strength and rising inflation expectations, hardly a harbinger of recession.
In this case, however, it may be tied to comments from a few Federal Reserve District Presidents questioning the need for any rate cuts either in September or the near term. And there is logic to their thoughts. GDP is still growing close to 2%. Leading economic indicators have started to rise again after several months of decline. They were up in both June and July. The consumer is still spending. Their balance sheets are solid with debt service to income still at a very low percentage and the savings rate over 8%. Employment is at a record high, unemployment is at a historic low and weekly jobless claims fell once again. Government spending is rising at a rate close to 4%. Thus, they argue, why any rate cuts at all?
But there is a flip side. Manufacturing is floundering. Early indications are that it actually fell in August. Economic growth overseas is weakening. Europe and Japan are teetering with recession and China’s growth is slowing. Negative interest rates beg for the Fed to move rates lower to close the gap. President Trump, who pleads in his own manner for the Fed to cut rates, cites the fact that Germany is issuing long bonds at negative rates giving it a supposed competitive advantage.
Yet one can respond, what advantage? If negative rates stimulate so much spending and risk taking, why is Germany and much of the rest of Europe moving toward recession? Japan has lived with interest rates either side of zero for 30 years without being able to achieve sustained growth. Negative rates could reflect fears of deflation, but they also could reflect the thinness of European sovereign bond markets given the fact that the ECB owns so much of the same sovereign debt. One could easily argue that negative rates scare both consumers and businesses. Businesses would gladly borrow at negative rates, but they would be reticent to lend. Once again, the key to sustaining economic growth is more demand, not more money.
Which brings me to (1) what might Mr. Powell say, and (2) how might markets react. Given that there isn’t yet consensus among FOMC members what to do in September, let alone beyond, he is likely to hint at another rate cut but go no further than that. Markets have built in reduced odds of anything more than a 50-basis point cut in rates in September so a 25-basis point cut would be received reasonably well. But markets are already pricing in 3-5 rate cuts over the next 12-18 months. Should Mr. Powell throw a wet blanket on that assumption markets could respond negatively. I shouldn’t try to guess today’s market. More important are the long term implications. The key question is whether the Fed should provide cover for future depressant actions by Washington, such as more increased tariffs, or should the Fed stay to its charter, concentrate on maintaining price stability and keeping growth on course subject to the data evident at each meeting. I would suggest that the mood of the Fed majority reflects the latter. It shouldn’t provide cover for future increases in tariffs or economic weakness in Germany. It should stay to its charter of keeping inflation within range of 2% while providing an interest rate environment to support sustainable long term growth. There is little evidence that current rates are far from what are needed to support those goals. I conclude that with the evidence of data. Inflation isn’t moving sharply up or down nor is economic growth.
Markets, of course, love low rates because the corollary is higher P/E ratios and higher stock prices. But short term gains can lead to long term pain. A race to zero interest rates has its obvious positives. But zero rates promote more debt. If rate subsequently rise, all that extra debt can result in debt service so high that it could cripple an economy.
My conclusion is that the Fed may need to tweak policy with a measured rate cut or two but chasing European policy of negative rates and quantitative easing in an economy that is still growing at trend makes little sense no matter how many times the President tweets, or trying to satisfy short term traders. It may lead to a brief negative market reaction but, in the long term, good policy brings good results. Markets will ultimately be satisfied.
Today, Kobe Bryant is 41. Rick Springfield turns 70.
James M. Meyer, CFA 610-260-2220