The stock market bounced strongly yesterday following a combination punch by two Fed officials. On Monday, St. Louis Fed President James Bullard said that a rate cut “may be warranted soon” if inflation remains low and trade-related uncertainties begin to more meaningfully impact economic growth. Yesterday, just slightly over four months after signaling a pause in interest-rate hikes, Fed Chairman Jay Powell said essentially the same thing. These comments are just the elixir that stock investors had been anticipating. They also represent yet another reminder that trying to time the markets is futile in the age of unrelenting Fed monetary support and a constant barrage of presidential tweets.
In the first chart below, we show just how dramatically the interest-rate outlook has changed over the first five months of 2019. The chart shows the implied probabilities for the target Fed Funds rate as of the last Fed meeting of 2019 in December. You will see that on December 31, 2018, the markets were overwhelmingly expecting that the Fed would maintain the current Fed Funds rate range of 2.25%-2.50%, represented by the gray bars, through the end of this year. In fact, the odds of a rate cut at that time (12%) were about the same as the odds of a rate hike (10%). As we got into March, though, things began to change. The incoming economic data increasingly suggested that growth was set to slow, perhaps meaningfully, from the first-quarter rate of 3.1%. At the same time, inflation continued to fall despite solid wage gains. As icing on the cake, increased trade squabbles with China increased uncertainty and began to more significantly impact corporate investment. These troublesome trends led the markets to anticipate a change of heart by the Fed. Still, the Fed held its fire. That is, until the stock-market plunge in May, the effects of which were compounded by the president’s announcement of punitive tariffs on Mexican imports.
The next chart shows that the weighted average implied Fed Funds target has dropped 0.58% from 2.35% at December 31, 2019 to 1.77% today. The lowered expectations imply that the Fed will cut interest rates by 0.25% between 2 and 3 times before the end of this year. While this may not seem like a lot, it is. This is especially true given that despite deteriorating economic data, a horrible May for stocks, and ongoing presidential pressure, no Fed officials had publicly discussed the possibility of rate cuts until yesterday. As such, the Fed’s capitulation over the past couple of days is likely to be seen as another instance of “the tail wagging the dog.” In other words, the Fed continues to be reactionary rather than proactive. Chairman Powell desperately wants to normalize monetary policy, but the markets, the economy, and ill-conceived policies are once again forcing his hand. This should come as a surprise to no one. The Fed has been reacting to markets for the better part of ten years.
The good news is that lower interest rates should help many sectors of the economy, especially the slowing housing and auto sectors. This stimulus could prove critical because absent some offset, there is little doubt that the opening of a new trade-war front with Mexico would cause economic growth to slow. The Federal Reserve had already expected GDP growth to slow to 2.1% in 2019 and 1.9% in 2020, so lower interest rates may help to offset some of the trade-related uncertainty that hadn’t really been factored in by the Fed when its projections were issued in March. As well, lower interest rates should help arrest the decreases in inflation and inflation expectations that have clearly bothered the Fed.
The bad news is that we cannot escape the cycle of loose monetary policy bailing out poor fiscal, trade and other policy decisions. Accommodative monetary policy (low interest rates) is a very blunt instrument that cannot solve all of our economic woes. In fact, artificially low interest rates over a sustained period of time can and have created new challenges, such as asset bubbles, the accumulation of excessive debt, the pulling forward of demand, and therefore a dependence on continued low interest rates. So while the celebration by stock investors may continue for a while, the longer-term outlook for the economy may be no better.
What should we do as investors? To reiterate, the current investment backdrop makes predicting short-term market gyrations more difficult than usual. Therefore, investors should avoid making rash, emotional decisions that could end up being very costly to long-term returns. Our advice is to maintain a long-term focus while drowning out as much of the short-term noise as possible. Volatility can create opportunities, but the impulse to be too opportunistic can also be fraught with peril.