Stocks fell amid a few rather weak earnings reports and commentary from the ECB that was very dovish and suggested that steps taken by the central bank could push rates further into negative territory. One could assume the ECB move would push the Fed to be even more aggressive with monetary policy although there are few signs so far that it will go beyond a 25-basis point cut in rates next week.
After the market closed there were a series of earnings reports, mostly quite strong, including Dow component Intel. Alphabet# also had a solid upside surprise as did Intel. However, while Amazon’s revenues were strong, its profit growth lagged previous quarters and the stock fell. Alas, it is earnings season.
As the week winds down, there will be fewer significant earnings releases. The focus on the next FOMC meeting will be magnified, particularly after the very dovish ECB meeting. While all indications point to a 25-basis point cut, the risk today is that the Fed’s actions may prove too little too late. How will we be able to tell?
If the Fed’s rate cut does not move the 10-year Treasury yield higher, particularly in the wake of a very expansive Federal spending bill winding its way through Congress, then the market’s message will be too little, too late, particularly if there is no upward movement in long-term Treasury rates. A cut in the Fed Funds rate is designed to stimulate investors and savers to take risk. That means spend more and invest in higher risk assets, e.g. stocks. Think of it like a sale in your favorite store. Will 20% off entice you to buy or do you wait for 40% off? With interest rates as low as they are, the Fed doesn’t want to cut rates more than they have to. Some might argue that with the economy still growing no cuts are needed. And they have a point. But with about a quarter of bonds around the world now traded with negative yields and hardly any government bonds offering the 2% yields of U.S. Treasuries, our market is a bit out of line. It remains a global world, at least in finance. Thus, a rate cut here is called for. The only question is how much. The Fed wants to be conservative. It doesn’t want to stay behind the curve. The danger is that a 25-basis point cut next week will be too little too late and long-term bond yields continue to fall. That may not be the most likely outcome but it is a distinct possibility. If long rates don’t act positively to a Fed rate cut, look for the probability of another cut in September and the possibility that the next cut could be 50 basis points. The Fed simply has to get in front of the market.
Why does all this matter? Because a negative yield curve, where short term rates are higher than intermediate to long term rates, incentivize banks not to lend. Banks borrow short and lend long. If long rates are lower than short rates, the incentive to lend dissipates. But by priming the economy, the Fed hopes to stimulate spending and to force investors to buy risk assets. Stocks are a risk asset class. If investors get insufficient yield from bonds or cash and buy stocks, prices will rise. That, in turn, promotes more spending, or so the logic implies.
But while the Fed can improve the spending environment, it can’t force spending. The good news is that consumers are already spending at a healthy clip, employment is high, and there are few layoffs. Thus, the odds suggest that the Fed’s strategy should work. The only question is how much stimulus (i.e. lower rates) is required.
We will see the answer shortly. If 25 basis points isn’t enough, bond yields will fall and equity investors will get spooked. If yields, however, begin to rise in anticipation of a better economy, stocks should do OK. OK isn’t great because the benefits of higher earnings could be offset by lower P/E ratios. The bottom line is that the next 6 weeks or so, the time between the July and September FOMC meetings, could be a bit rocky. After a 20% rise in stock prices this year, that wouldn’t be so terrible. I don’t expect any major decline but a 5-10% correction over the next 6-8 weeks wouldn’t be a surprise either.
I wouldn’t suggest changing one’s asset allocation as a result, but I would take some profits in stocks that have had sharp and unsustainable moves up lately and build a shopping list for opportunities should a correction occur.
Today, Sandra Bullock is 55. Kevin Spacey is 60. Helen Mirren turns 74. Mick Jagger turns 76.
James M. Meyer, CFA 610-260-2220