Stocks rose slightly Friday in very light mid-summer trading. The bond market was quiet as well. Going into this week’s FOMC meeting, the yield curve is very flat with a slight inversion dip in the early years and a slight rising trend amid long-term maturities.
This week, approximately 150 S&P 500 component companies will report earnings. It will be the busiest week of earnings season. It will also be a busy week for economic data with employment and manufacturing information the most important. The FOMC meeting will precede the release of most of the important data.
The FOMC meeting this week, where the Federal Reserve is presumed most likely to decrease interest rates by at least 25 basis points, will be one that we look back on a highly important change of direction. There have not been rate cuts since well before the Great Recession. Rate cuts normally are a result of the Fed wanting to create a foundation for increasing demand to rescue an economy that is in or coming out of a recession. While growth has slowed in recent months, last week’s Q2 GDP report showed growth of 2.1%, very close to the post-recession average. If it were not for weaker trade volumes and inventory reductions in the quarter, growth would have been higher. Virtually no one is predicting an imminent recession. Clearly, therefore, a rate cut is not about either lifting the economy out of recession or saving our economy from going into recession.
But, as we all know, the Fed has two mandates. Maintaining or supporting growth is one. The other is maintaining price stability which, by the numbers, today means keeping inflation at or above 2%. Why 2%? Because a number materially higher than 2% suggests an economy running too hot and threatening to create excessive inflation that would rob all of us who have any savings of a meaningful loss of purchasing power. A number materially below 2% would raise the threat of deflation. The evils of deflation center on the notion that in a world of falling prices, consumers would delay purchasing anything until needed since falling prices will lead to better bargains later. History shows, in addition, that arresting deflation is very difficult, requiring massive monetary easing. A look to Japan’s economic history over the past three decades serves as history to that.
Our inflation has been closer to 1.5% than 2.0% in recent years and threatens to go a bit lower without easier monetary policy. That is the single biggest reason for a projected rate cut. The Fed also takes its cues from the bond market. An inverted yield curve, where rates actually decline as duration increases is a clear signal that (1) the markets believe inflation is going to decelerate, and (2) markets believe the Fed is going to do too little too late. Indeed, that supports the minority opinion today that the way to get back in front of the market is to decrease the Fed Funds rate by 50 basis points on Wednesday.
One should note that central banks, via interest rate policy and other tools at their disposal, can only create an environment that would stimulate demand. But they can’t create the demand. If a 25-basis point cut (or even 50 for that matter) is insufficient to entice greater spending or more risk taking, then the yield curve will stay inverted and either new or more aggressive solutions might be necessary. One adjunct to a rate cut this week, for instance, is a likely pronouncement that the Fed intends to stop reducing the size of its balance sheet immediately.
How will markets know if this week’s actions are effective? One probably can decipher the market’s immediate reaction by how the shape of the yield curve changes over coming weeks. Since everyone today expects a rate cut of at least 25 basis points, that is already priced in. Over the past several weeks, since the likelihood of a rate cut has increased, the yield curve has uninverted somewhat and returned to a very flat line with a few waivers. That implies that an announcement of a rate cut alone won’t be sufficient to steepen the curve further. The cut must be accompanied by post-meeting comments by Fed Chair Jerome Powell that the Fed will continue to move aggressively to lift core inflation using whatever tools are available. The Fed doesn’t want to use all the arrows in its quiver, attempting to raise inflation a fraction of one percent within an economy that is growing at long-term trend rates. But it doesn’t want to see inflation decelerate meaningfully from here. It therefore has a rather narrow path to follow and any deviant change in course could have unwanted consequences.
Another key issue arises from this whole debate. Is 2% the proper target for inflation, given the world has been functioning well economically for many years with inflation measurably below target? Maybe in a world vastly oversupplied, the target, at least for now, should be a bit lower. If you are a regular reader of my comments, you know that I often point to worldwide oversupply of virtually everything as the chief cause of below- trend inflation. In a fast-growing industry, like semiconductor manufacturing, an inventory oversupply can be corrected within a few months if manufacturers slow production and demand eats into inventory excesses. But in a world of 2% growth, it will take a long time for rising demand to absorb excess inventory and supply.
Look at the oil market. Beginning in late 2014, prices started to crater as fracking led to a vast increase in supply. Saudi Arabia and Russia continue to pump oil at very high rates in the hopes that low prices would stop capital spending to find more oil, especially in the U.S. where fracking technology led to a surge in production. Prices did fall (by about 75%) but they didn’t begin to rebound until the Saudis and others agreed to curtail production. That worked and eventually prices returned to over $70 per barrel. But even as the Saudis continued to limit supply, $70 oil brought to markets even more investment and more supply. Thus, prices fell once again to current levels. Therefore, even with major suppliers still curtailing production, the long-term price trend for oil is down.
As noted, oversupply is everywhere. China’s economic surge was based on producing cheap goods to serve world needs. In many cases (i.e. steel), China created enormous excess capacity. Attempts to dump that excess on world markets led to tariffs. You know the rest of the story. China responded by either putting on its own set of tariffs of other goods or simply curtailed buying. As a result, soybeans rot in warehouses and prices tumble.
Housing economists point to a lack of listings to account for tepid demand. Hogwash! No one who wants to buy a house will tell you they can’t find one although they may tell you they can’t find one they can afford. On the flipside, sellers moan that buyers won’t pay their price. The solution to both is obvious; it is to lower prices. Sellers aren’t listing homes because they know they can’t get the price they need to justify moving.
One rate cut isn’t going to solve an oversupply problem. At the edges it might help, and if it leads to a steeper yield curve, that will be a healthy move. Oversupply didn’t happen in a day and it won’t be solved in a day. It will likely take years for inflation to move persistently above 2%. In the meantime, the reality is that a steady-state growth rate, governed by demographic growth and modest productivity gains, is probably very close to 2%. President Trump is running for reelection and wants to be able to see that growth under his administration has been substantially higher than under President Obama or Bush. Therefore, he will pull whatever growth levers he can while cajoling the Fed to move further in the direction of easy money. That is probably one reason he was so quiet this time around when Congress passed a massive spending bill, one he promised not to support the previous time he reluctantly supported similar legislation. And the increase in spending will help to increase demand, recognizing the evils that will lurk in the future from a cocktail of massive debt balances and even slightly higher rates.
The net of all this is that a rate cut is coming and the bond market’s reaction will tell us how much more easy money is needed. Mr. Powell is likely to suggest he is open to further rate cuts if necessary. Growth, however, is not likely to increase much. The lack of buoyant capital spending will limit productive growth in the future. Stock markets love low rates. They have priced in a 25-basis point cut on Wednesday and believe at least one more is coming in September. As long as Mr. Powell sings that tune, markets should remain relatively strong. On the surface, a 50-basis point cut, now less than a 25% probability, would lift prices further, but that depends on the messaging accompanying such a rate cut. If the yield curve in coming weeks starts to return to a normal shape that goes along with moderate economic growth, that would be well received. However, if inversion remains or gets worse, the market’s signal would be “too little, too late”. Markets aren’t always right but they won’t react well to further rate inversion. As noted, our economy remains solid and the consumer remains confident. There are always reasons to be concerned but now isn’t the time to worry excessively.
Today, country singer Martina McBride is 53.
James M. Meyer, CFA 610-260-2220