The Dow’s six session winning streak ended yesterday as a solid early morning rally faded. Continued dissatisfaction with the recently announced United Technologies/Raytheon merger drove the price of United# lower for the second straight session. That alone was enough to move the Dow Industrials into negative territory as United Technologies is a Dow component. With that said, the pace of the rally simply wasn’t sustainable without a strong uptick in economic data. The only major release yesterday, a modest and expected rise in producer prices for May, wasn’t market moving in either direction. As noted Monday, with stocks now back near all-time highs once again, equities need a catalyst that would either push interest rates down further or earnings expectations higher.
While markets are pricing in at least two rate cuts of 25 basis points each between now and the end of the year, that isn’t a forgone conclusion. There is a good argument against any cuts in an environment that seems to indicate growth of about 2% can be sustained for some period of time. Why create stimulus in a growing economy? Why not save the stimulus fire power until a more crucial time? And why cut rates, a tactic to stimulate growth, while continuing to slowly reduce the size of the Federal Reserve balance sheet, a negative to growth?
The Fed has two mandates, one to maintain price stability and the other to stimulate economic growth. Both are to be done in concert. With that said, the Fed toolkit is more effective as a method to control price stability than as a weapon to raise growth levels. Prices are a function of supply and demand. The Fed, in conjunction with the Treasury, can clearly have a giant impact on the supply and cost of money. While its policies don’t impact demand quite as much as supply, the Fed’s weapons to fight inflation and deflation are stronger than anything Congress or the White House have. That is not to say that fiscal policy can’t be overly stimulative or constraining. But government spending represents well under a quarter of GDP and that includes state and local governments as well as Federal spending.
As for managing growth, by making the cost of borrowing higher or lower, the Fed can affect demand, but it is only one factor in the supply/demand equation. The Fed can’t create jobs. It only has an indirect effect on the mood of consumers. It clearly can affect industries, like housing, that are heavily dependent on the cost to borrow, but it has a much smaller impact on whether I buy a new summer wardrobe or not. Of course, maintaining price stability, in and of itself, has an impact on demand and confidence. Deflation precipitates hoarding and lowers spending. Why buy today when it will be cheaper tomorrow. On the flip side, hyper inflation reduces any incentive to save unless interest rates are kept above the rate of inflation.
Assuming the Fed isn’t too far off base in its effects to anchor short term interest rates, other economic forces take over and growth generally continues based on population growth and some normalized level of productivity gains. Right now, there is a growing debate whether the Fed, after four rate increases last year, did indeed get too far off center and ended up creating market distortions. The centerpiece of that possible argument is the inverted yield curve in the 0-5-year maturity range. The yield for the shortest duration assets is tied directly to the Fed Funds rate, currently centered around 2.4%. But the market has now priced 2-year Treasury yields under 1.9%. In normal markets, yields are higher as maturities get longer for obvious reasons. When, however, they invert as I just showed for the 0-2 year range they both send a message that the Fed is out of step and they begin to have a real economic impact. Saving rises because of the relative attraction of money market and CD rates to other alternatives. A 2.25% return, versus inflation of well under 2% provides real value with almost no risk. Second, banks borrow short and lend long. When the yield curve inverts, spreads narrow and banks become more reticent lenders. While the inversion this time around has only been for a couple of months, the impact so far has been relatively modest. However, if one looks at monetary velocity, the rate at which money turns over, it bottomed last year and was on a steady path up until the yield curves began to invert. Then velocity stopped improving, and it has started to edge back down once again. A monetarist view of GDP is money supply times the rate money turns over (velocity). If money simply sits and is never spent, there wouldn’t be any economic activity. Thus, all other things being equal, the Fed wants to see a healthy velocity of money. As long as rates are inverted, that won’t happen.
An obvious additional question is why did rates invert? And the obvious answer this time around is that inflation simply hasn’t appeared. Tariffs, a tax on imports, was supposed by many to be inflationary. But overseas supplies have absorbed a healthy percentage of the cost of tariffs to date and little has been passed on to consumers so far. That might change if the rate of tariffs were to be increased further. It was also assumed that as the unemployment rate fell, the pace of wage increases would rise. That has happened but at a very slow pace. And attendant improvements in productivity have offset the impact of higher wages. While it is theoretically obvious that at some point labor shortages could become severe enough that productivity gains alone won’t be enough of an offset, we don’t seem to be at that point yet. Moreover, recent monthly employment gains have slowed suggesting the point where wage pressures increase could be further out than expected.
Thus, next week, when the FOMC meets once again, the argument to possibly cut rates isn’t about sustaining growth. It is about giving the market a stronger push to help raise the level of inflation toward the Fed’s 2% target. While the Fed, economists and Wall Street focus on real rates of growth, in our everyday lives we live in a world of nominal GDP. When a company reports sales most of the time, we don’t know how much was volume and how much was price. When we receive a pay check, it is in nominal dollars; there is no adjustment for inflation. Thus, if real GDP growth falls from 3% to 2% and inflation falls from 2% to 1.5%, the combination is more substantial than one might think. Nominal GDP growth goes from 5% to 3.5%. When sales grow 5%, companies have some wiggle room to improve margins or to invest a bit more for the future. But a 30% decline in the growth rate, nominally, clearly forces companies to pay more attention to every penny spent. That is part of the reason that investment spending growth has slowed.
So, will the Fed cut next week? Markets suggest that is a strong possibility but not a certainty. The Fed tends to be cautious. Do they wait for more data and wait until its next meeting at the end of July? It could. Does relentless pressure from President Trump challenge Fed independence and cause it to hold off as a result? It may, but I think the Fed wants to act independently. If the FOMC feels a rate cut today makes sense, I think it will do so regardless of pressure one way or another from the White House.
Clearly, it appears in hindsight that 2-3 increases last year might have been better than 4. Obviously how President Trump proceeds with tariffs against China will impact both growth rates and prices. Jerome Powell, the Fed President, is a businessman, not an economist. He isn’t blind to the world or to markets. He communicates regularly with business and Congress. He isn’t afraid to change directions if necessary. If rates rose too far or too fast last year and need adjusting, he will do that. Would waiting another six weeks matter?
The message of this past December and January are construction. Clearly markets responded very sharply against the December hike. Mr. Powell got the message and made it clear within a couple of weeks that no further rate increases were forthcoming. Markets reversed their September to December slide and, by late April, were back at all-time high levels. Should the Fed fail to cut rates next week, markets are likely to react negatively, probably not as vociferously as it did in December but still sending a loud message. If the reaction is more severe than expected, Mr. Powell has time to send an early clue that he hears markets and will respond in July. If markets fall but in an orderly fashion or simply stay relatively flat, he might wait past July. By markets, I mean both the equity and bond markets. If the shape of the yield curve becomes more inverted, that would generate a stronger post-meeting response.
The bottom line is that this Fed is going to get it right. The only question is whether it will happen now or a couple of months from now. It is also possible that the Fed waits, economic data starts to improve noticeably, and the Fed can wait indefinitely to move rates. That is an argument for waiting until July or later. The key, though, for long term investors, is that this Fed isn’t going to stubbornly fight the markets. Rather it will stay in step. It won’t react to weekly or monthly market gyrations unless they become extreme, but it will stay in synch over the coming months and even years. That should give investors comfort recognizing the obvious near term risks associated with next week’s FOMC meeting.
Since there are no real significant birthdays of note today, I want to acknowledge two who were born on this date. George H.W. Bush would have been 95 today. Anne Frank was born 90 years ago today.
James M. Meyer, CFA 610-260-2220