Stocks started off strong yesterday but lost all their gains by session’s end as rumors flew that China was getting more obstinate in its trade talks with the U.S. There are going to be ebbs and flows to these negotiations until they come to some sort of conclusion, probably during the spring. Given recent market strength, some profit taking was in order anyway.
Today’s big event should be the conclusion of the FOMC meeting followed by a post-meeting press conference with Chairman Jerome Powell. Coincident with the release of a post-meeting statement, the Fed will issue a dot plot of forecasts from each of the participating members of the FOMC committee meeting. Last time, the consensus outlook was for two rate increases in 2019, down from 3 or more the previous time. Now consensus will probably suggest just one with some members suggesting no increases in 2019. Each participant will also weigh in on his or her forecast for economic growth, unemployment and inflation.
But in reality, none of this matters a whole lot. Because while markets obviously react to Fed actions, Fed actions are largely dictated by markets. This morning the 10-year Treasury bond yields 2.59%. That is roughly 10 basis points or a bit more below the rate in January. Fed Funds rates now trade around the 2.4-2.5% range. Two-year Treasuries this morning yield 2.45%. Five-year Notes are yielding 2.40%. Thus, we see two facts clearly. First, the yield curve out to 5 years is essentially flat with little ripples of maybe 5 basis points along the way. Second, the 2-10 year spread is now less than 14 basis points. Were the Fed to raise interest rates a quarter of a percentage point without any change in inflation expectations, it would almost certainly create an inverted yield curve where the front end, anchored by the Fed Funds rate would have a higher yield than the 10-year Treasury. Without a robust increase in inflation expectations, the Fed simply wouldn’t have any reason whatsoever to do that.
So, when you read you business daily or turn on CNBC or Bloomberg television and listen to pundits predict when the next rate increase will be or how many increases to expect this year, pay as much attention to what you hear as you would for a forecast of rain or sunshine some day in June or September. The correct answer is that the markets will tell the Fed when the next move might be necessary. If the next move is going to be higher, the 10-year Treasury will have to be about 2.85% or greater. That will only happen in an economy where growth is accelerating and inflation expectations are rising. We can all guess when that might happen. I, for instance, have noted recently that Q1 will probably be the quarter of slowest growth in 2019. But as for inflation expectations, there are few signs of any rise in pressure. Wage rates are going higher at a slightly elevated pace but so is productivity. The Fed will have to see more than a month or two of rising inflation before it moves. Could it move once or twice this year? Of course it can. But if it does, it will be because the U.S. economy is much stronger than currently expected. I am not so sure I would call that bad news.
What about a possible rate cut? Again, look at the market. If the 10-year Treasury yield continues to slip lower and falls below the Fed Funds rate, the FOMC committee would have to take that as a strong signal that markets felt growth was going to continue to slow and/or that inflation expectations were falling well below the Committee’s target of 2%. That would definitely put a rate cut decision on the table.
Mr. Powell has said since the moment he took office that the Fed was going to be data dependent when it came to making rate decisions. The Fed as a whole or each individual member of the FOMC has opinions where they believe our economy is headed over the next 3 months to 2 years. But those opinions matter little if not supported by near term data. Another way to look at the situation is to say that while there is still a bias in thinking that the next rate move will be higher, whether it be as early as June or as late as next year, the Fed today is pretty close to neutral. Pure neutral would suggest there is a 50-50 chance that the next move will be up or down. That suggests forces other than Fed moves in interest rates will dictate our economic future.
The Fed also today will try to clarify when it expects to stop lowering the size of its balance sheet. The consensus prediction is some time before year end. But this matters less than the future direction of rates. Yes, change in the size of the balance sheet matters as does any change in the duration of assets held. But this discussion is hardly one that should move markets in a big way.
Looking back to early last fall, the Fed’s message has changed significantly. Six months ago, it was on a path toward 4 increases in 2018, 3 more in 2019 and possibly another 2-3 in 2020. Now, having done the 4 in 2018, the path is for 0-1 this year with not even an educated guess what is to come in 2020, although one should note that any increase in 2020 will be accompanied by a Presidential Twitter rant chastising the Fed for being anything more than wildly accommodative.
Of course, the economy isn’t just a function of the Fed. Trade has been front and center since President Trump initiated tariffs on steel and aluminum last spring. China is clearly the topic du jour and markets can swing pretty dramatically depending on changing odds for a robust deal with China or not. For all the talk from the White House of how it was going to change the trade landscape, so far all we have is a deal with South Korea, a lot of tariffs, and a lot of talk. The replacement for NAFTA is in jeopardy. It requires Congressional approval and that is far from certain. The Trans Pacific Partnership (TPP) is moving forward without U.S. involvement. Mr. Trump is rattling sabers regarding auto tariffs on European cars and parts imported to the U.S., but lately the rhetoric there has subsided and the actual odds of any tariffs, at least at the moment, are low.
Stocks have gotten off to a good 2019 start. Part was a recovery from an overly pessimistic market in late 2018. Part reflects Q1 slowness all over the world but expectations that growth will resume later this year. Part relates to tariffs still in place that could disappear or at least be reduced before long. FedEx’s# earnings last night serve as a reminder that trade activity is being hurt by tariffs. But perhaps the biggest boost is an expectation that the Fed will not increase rates any time soon. One cautionary note is that news regarding the Fed can’t get much better than it is now. The perfect world is low interest rates and minimal Fed intervention. That is what you have today. For stocks to move higher, growth rates have to pick up later this year. Earnings growth will be helped by reduced pressure after May from a strong dollar as the year-over-year change, while still negative, will be drastically reduced in the second half of 2019.
Stocks today are fairly valued. With the right set of factors, they could become overvalued. But as we saw last fall, valuations can correct sharply as well depending on the set of circumstances. In that regard, we are in a no man’s zone where market forces alone shouldn’t provide either a strong headwind or tailwind for markets. It, therefore, comes down to individual company performance. The key, as always, is the ability of each company to meet or exceed future expectations.
Today, Barron Trump turns 13. Holly Hunter is 61. Director Spike Lee is 62. Bobby Orr turns 71.
James M. Meyer, CFA 610-260-2220