Stocks fell sharply on Friday as bond yields sank and the yield curve inverted in spots causing equity investors to worry that a recession was near.
To understand what was happening, we have to go back to Wednesday afternoon’s FOMC meeting statement and Chairman Jerome Powell’s post-meeting press conference. Investors had expected some incremental dovish behavior, perhaps lowering predictions of future rate increases for 2019 from 2 to 1. Instead, what the Fed delivered was a resounding statement that no further rate increases are likely for the foreseeable future. Markets reacted and, at least according to the Fed Funds futures, came to the conclusion that the next rate change would be downward and it could come as soon as this fall. That is quite a change from last fall when the Fed was contemplating three rate increases this year and perhaps as many as two more next year. While markets love low rates, this time, at least based on trading Friday, investors were spooked by the Fed’s sudden accommodative stance. With inflation still running below the 2% target and growth slowing, one had to question whether growth would pick up again any time soon. That fear was reinforced by a sharp drop in Germany’s manufacturing index.
With that said, there remain good reasons to expect growth to continue, albeit at a moderate pace. One reason Germany’s PMI was so low related to changing regulations on German cars that took effect the first of this year. That led to a buildup of inventory of cars before the 12/31 deadline and a dearth of orders subsequently until that extra inventory is worked off. With that said, however, Europe is going to remain weak until Brexit is solved. That has been delayed, but delay and solved are not synonyms. In fact, the longer the delay, the worse Europe’s GDP will likely be. China continues to slow, but there are increasing signs of stabilization. As for the U.S., manufacturing is weaker than it was, thanks to weakness in Europe and tariffs, and the consumer isn’t spending as robustly as he was before Christmas. But there are signs that housing activity is starting to percolate as interest rates fall.
With the 10-year Treasury now below 4.5%, mortgage rates are down almost ¾ of a percentage point from their peak. Housing prices are no longer rising at the pace they were just a few months ago. The combination of flatter prices and lower rates means monthly payments for prospective buyers are falling, a sure factor that should stimulate demand.
An inverted yield curve almost always portends a future recession within the next 2 years. But the yield curve everyone was worried about on Friday isn’t quite inverted in the context needed to be considered a true barometer of a future recession. On Friday, the Fed Funds rate and the 10-year Treasury rate were about the same. In between, rates were lower 1, 2 and 5 years out, creating the slight inversion that sent investors fleeing. While Friday’s action was worrisome, one day isn’t quite a trend. If the curve is really going to invert and stay that way, we have to watch a few more days and weeks. Note that the 2-10 year spread that most focus on remains a positive 14 basis points.
The reason an inverted yield curve is so worrisome is that lenders make less money as the spread between long and short term rates becomes less and less. As the spread narrows, lenders have less cushion and become more reticent lenders. That means fewer loans, particularly for smaller businesses and less economic activity ultimately leading to recession. A few wobbles in the curve aren’t overly threatening yet, but clearly a few more days like Friday will create more risk.
The Fed, for now, is on the sidelines. Unless there is a substantial inversion, don’t look for the Fed to do anything. It certainly won’t raise rates again any time soon but, with the Fed Funds rate only around 2.35-2.40%, the Fed will have to think hard before lowering the rate without some more overt signs of economic weakness. It simply doesn’t have a lot of fire power to combat a recession so what it has should be used carefully. With wages rising at a slightly accelerated pace, there also is no real evidence that inflation could morph into deflation any time soon.
We have seen one-day air pockets in the market multiple times in recent months. For now, it would appear that Friday’s action is nothing more than a one-day event. That is not to say that a 5-10% correction couldn’t happen at any time. The release of the Mueller Report conclusions over the weekend should have no impact on the market. Bond rate changes this morning are very modest, suggesting calm could be restored fairly quickly. We are only 2-3 weeks away from the start of earnings season. That could affect volatility. Q1 is likely to be the weakest of the year, a combination or decelerating growth and a strong dollar. But we expect growth to stabilize or improve in the second quarter and by the second half of the year, the dollar will be only a modest weight on earnings. Thus, Friday’s wobble raises some justifiable concern but, for now, the economic case is still positive.
Today, Danica Patrick is 37. Sarah Jessica Parker is 54. Sir Elton John turns 72.
James M. Meyer, CFA 610-260-2220