Hold All Tickets!

After it was all said and on Wednesday, the Fed effectively reinforced the message that its two interest-rate cuts to date represent more of a “mid-cycle adjustment” than anything else. Chairman Powell clearly left the door open to additional rate cuts, but his rhetoric suggested he didn’t believe more would be necessary. The US economy, according to the Fed, remains on solid footing even in the face of the trade war with China, economic sluggishness outside the US, and continued weakness in business investment and the manufacturing sector. And once again, we have the US consumer to thank for our good fortune. Low unemployment, job security and rising wages are emboldening consumers to spend freely, and the Fed believes this will remain the case. Perhaps just as important, moderate- and lower-income folks are finally starting to more fully benefit from the economic expansion. More money in more pockets is the key to higher and more sustainable rates of economic growth.

This message seemed to satisfy investors, if not President Trump. It was a fine line to walk, but Powell did a masterful job . . . for now. But while the markets were stable yesterday, investors remain divided on the economic outlook. In the bond market, long-term rates remain depressed and the yield curve remains pretty flat. It seems safe to conclude that bond investors aren’t necessarily convinced about the positive economic narrative. Stock investors, on the other hand, appear to be buying what the Fed is selling. The major market indices are yet again knocking on the door of new all-time highs. Does the strength in stocks reflect a lack of investment alternatives in a low rate environment, or are stock investors anticipating that the cycle of downward earnings revisions that has been going on for several months will soon reverse? It’s hard to say, but eventually the bond and stock markets will have to converge.

In the days and weeks ahead, it will be critical to watch the yield curve to gauge whether or not the Fed has done enough to stabilize the economy. In theory, the yield curve should start to normalize, or steepen, if and when economic fears recede. Yields on longer-term bonds should start to rise, indicating that better growth and higher inflation lie ahead. On the other hand, if the yield curve remains flat or becomes more fully inverted, this would be a clear indication that investors are losing confidence and therefore the Fed has more work to do. Right now it’s hard to determine which way it will go. Bond yields have rebounded a bit in September, which could be a positive sign. But the spread between the yields on the 10-year and 2-year Treasuries, now at just 4 basis points, appears to be shrinking again.

It’s also worth noting that the markets don’t necessarily agree with the Fed about the need for more rate cuts. Below we show the Fed’s “dot plot”, which depicts each Fed participant’s projections with regard to the Fed Funds rate at the end of 2019, 2020, and 2021. You may notice that the dots for 2019 and 2020 appear to be clustered around the current Fed Funds target of 1.75%-2.00%. This tells us that the median (and average, for that matter) Fed participant expects no more rate cuts between now and the end of next year. Interestingly, five of 17 participants believe the Fed Funds rate will actually be higher than its current target by the end of 2019. For 2020, the number is 7. It seems pretty clear that there is not much consensus at the Fed right now. Still, nobody is seeing a dramatic turn one way or the other. Market expectations appear to lean more bearish than the Fed. The Fed Funds futures market, which represents real investors betting with their money, still says there is a 67% chance of at least one more Fed cut this year (49% chance of one more cut and 19% chance of two more cuts). Will the Fed or the markets prove correct?

Chairman Powell and the Fed deserve credit for steering us through some trying times while not spooking the markets and maintaining their independence. But their job is far from done. There is a wide range of possible trajectories for the domestic and global economies, and most will require a steady hand at the helm. President Trump should probably say “thank you” rather than continuing to berate Powell and the Fed.

Investors have been well served by being more cautious in recent months. Continued caution through this uncertain period makes great sense to us.