Stocks posted strong gains yesterday, a day after very dovish comments from the Federal Reserve. Interest rates tumbled across the board while the dollar strengthened after losing ground on Wednesday.
This morning the 10-year Treasury yield is below 2.5%. Just a few months ago it was at 3%. Last September, the Fed strongly suggested that it would complete four rate increases in 2018 and probably do another three in 2019 and possibly two more in 2020 bringing the Fed Funds rate up to 3.5% or higher depending on how rapidly inflationary pressures start to rise. Those comments precipitated what turned out to be an almost 20% selloff in the stock market. By December, the tune had changed. The Fed did implement its fourth-rate increase of 2018 bringing short term rates to around 2.4%. But instead of forecasting three more increases in 2019, it hinted that, at least for the time being, it would pause and watch as the impact of 2018’s four increases wind their way through the economy. By the January FOMC meeting, the tone got even more dovish. No increases were announced; that had become a foregone conclusion. But in post-meeting commentary, the Fed suggested that maybe only two increases would be necessary in 2019, and that could be it for a while. In fact, Chairman Powell indicated that rates were now at the bottom end of a range he would deem neutral. Previously, he had suggested neutral might be closer to 3%.
This week, the Fed got even more dovish. Now it suggests no more increases are likely this year, maybe none for the rest of this economic cycle. Futures markets are now pricing in a one in three chance that the next rate change could be a cut. At first, markets celebrated the news leading to yesterday’s rally. Low rates are a stock market’s friend because the corollary is higher P/E ratios. But with rates tumbling, perhaps markets now conclude that the much more dovish stance than anyone expected is a signal that world economies are weaker than expected, and central banks are concerned that the weakness could ultimately lead to something more severe, like a recession.
Thus, today the yield curve is dead flat. Treasury bills and 10-year bonds trade at basically the same rate. Five-year notes actually trade at a slightly lower yield. While some will try to create a big headline that part of the curve is inverted, if you step back and look seriously, what you will see is a wobbly horizontal line. That is scary enough, but one shouldn’t overread the consequences, at least not quite yet. Rates around the rest of the world have begun to turn negative again. For instance, German bund 10-year yields are now negative this morning. Is this fear of further growth deceleration, or is it a bond market statement that inflation is MIA? Maybe a bit of both.
Economic data strongly suggests the first quarter of 2019 will be the weakest in some time. It will continue a deceleration that began last summer. But we have all been fooled by weak first quarters for years, and there are pretty strong signals that this may be happening again. At the same time, White House predictions of an economy that can sustain 3% growth appear fanciful at best. More than likely, growth in the U.S. will be anchored by a moderating growth of the labor force, perhaps closer to 1% than the near 2% experienced the last few years and slow gains in productivity. The case for an outright recession, something that will be spoken about more as the yield curve flattens, is still rather weak. Not only is the work force still growing, but unemployment claims are near all-time lows. Corporate earnings will decline in the first quarter, not because of economic weakness, but due to the strength of the dollar, and its impact on the translation of foreign earnings. Growth overseas is slowing as well, but it is still at or above growth rates here in the U.S. The best case continues to be slow growth without any substantive inflationary pressures. That should be good for stocks, not bad.
Indeed, if rates are going to stay lower for longer, and inflation is to remain non-threatening, then P/Es should expand, and earnings should begin to reaccelerate in the second half of the year. There are two ways for investors to play these changes. First, widening P/E ratios favor higher multiple growth stocks. It was no accident that tech stocks led yesterday’s rally. Second, buying companies with good cash flows and growing streams of dividends that provide investors yields in excess of Treasury securities will be very appealing. Note yesterday’s strength in REITs for instance. The losers yesterday were the lenders, banks in particular. While a better economy should stimulate greater loan demand, the net interest margin (the spread between a bank’s cost of funds and interest earned) will contract in a flat yield curve environment. However, if growth does resume as we expect, the yield curve will steepen, and bank investors will be rewarded.
Other industries that will benefit from lower rates are those that depend on financing for part of the purchase. The two obvious industries are housing and autos. Both did well yesterday.
All this assumes that there is no escalation of trade wars either between the U.S. and China or elsewhere. While most believe tensions will ease by mid-year, nothing today can be taken as a foregone conclusion. The flattening yield curve may create some near-term wobbles in the stock market, but the trend is higher, and weakness should be seen as a buying opportunity.
Today, Reese Witherspoon is 43. Novelist James Patterson is 72. William Shatner turns 88.
James M. Meyer, CFA 610-260-2220