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Fallout From Fed Dovishness

The rate setting committee of the Fed met on Tuesday and Wednesday, March 19 and 20.

What the Market Saw and Heard

From their formal statement and press conference, the equity market saw and heard only what it wanted, at least at first, and equity markets rose on Thursday, March 21st (Dow Jones +217):

  • No rate hikes in 2019, and possibly only one in 2020 (and that one would occur because the current “soft patch” will have passed!);
  • An end to the Fed’s balance sheet reduction thus preserving high bank reserve balances and implies that interest rates can stay low.

What the Market Ignored

Here is what the Fed actually said that the equity market initially ignored (this is from the opening paragraph of the FOMC press statement):

“…economic activity has slowed… payroll employment was little changed…recent indicators point to slower growth of household spending and business fixed investment.”

That statement says a lot. It should be of concern to markets that the Fed has acknowledged a significant U.S. slowdown, as they reduced their GDP growth outlook to 2.1% from 2.3% for 2019 and to 1.9% from 2.0% for 2020. The Fed also reduced its inflation forecast accordingly.

When asked at the press conference, Chair Powell said he doesn’t see a recession. Ask yourself what the market reaction would be if he said he foresaw one? It just isn’t feasible, from a market movement perspective, for any Fed Chair to forecast anything but economic stability. If they did otherwise, they would be shirking their sworn duty to keep unemployment and inflation low.

The Fed also announced that they would slow the balance sheet run-off from $30 billion/month through April, to $15 billion/month through September, then to $0. Note that this continues the tightening, though at a lesser rate beginning in May until September when the tightening stops. (Historical Factoid: In the three soft landings (out of 13 rate-rising regimes) that the Fed has engineered in the post-WWII era, by this time in the cycle they had already significantly eased.)

Bonds Know Better

The bond market, on the other hand, concluded that the real cause of the Fed’s dovishness was not the lack of inflation, as that is just a symptom. The bond market zeroed in on the Fed’s concern for growth and the implications of that. As a result, the 10-Year Treasury Note yield fell from 2.60% to 2.40% (as of this writing), now inverting against the Fed Funds 2.50% upper limit, and also inverting against the 3-month T-bill. Such inversions often are prelude to oncoming recessions, and the financial press has zeroed in on this factoid.

At the same time, the futures market is now pricing in a near 60% chance of a rate cut by 12/31/19 (and, of course, a rate cut should signal real concern regarding near-term economic growth). The markets also now show the odds at 0% for a rate hike in 2019. A month ago, the odds for the rate cut were 18%, and they were 23% just prior to the Fed meeting.

So, the bond market is clearly in sync with the idea that growth will stay weak and that recession in the near term is a distinct possibility.

The FedEx/Nike Pulse

One recent notable market development was the unexpectedly soft FedEx earnings release. The company is often considered to reflect the “pulse” of the economy, especially the consumer, and is considered by some to be the “canary in the coal mine.” The fact that the company missed on both profits and revenue is telling. And they lowered guidance again (having lowered it with their earnings release last December). Their press release said the results were due to “slowing international economic conditions and weaker global trade growth.” Note that they said nothing about the economic “soft patch” being “temporary.” In fact, a lowering of guidance says just the opposite. Nike, too, disappointed with weaker than expected North American sales.

In addition, the latest data out of Europe are raising concerns that the “soft patch” simply won’t pass as per the narrative. According to IHS, March German manufacturing output was at a six-year low! And the latest readings from both the Dallas and Chicago Feds show continued slowing in business in their regions.

The Economic Landscape

By the time Friday morning (3/22/19) came around, the equity markets seemed to have gotten the message that the Fed was worried about future growth, and the Dow Jones closed down 460 points.

The market is now recognizing that economic growth for 2019 and likely 2020 will be less than 2%, and could be much lower due to:

  • tariffs which raise consumer prices of those goods being “taxed;”
  • the fading impact of fiscal stimulus (the tax cuts);
  • labor shortages triggering output cutbacks (from the Philly Fed survey);
  • excessive student debt crimping the finances of younger generations;
  • the lagged impact from prior Fed rate hikes and the fact that any future rate cuts will take several quarters to have a significant impact.

Conclusion

PE ratios are quite high relative to their historic mean, and markets will continue to be volatile when earnings disappoint (FedEx, Nike) or the macro data show continued weakness. The equity market has put a lot of faith in the Powell “Put.” Perhaps a large bout of downside volatility will put the “Put” to the test, i.e., whether Powell & Co. will actually ease policy with a rate cut in order to protect the equity investor. Only time will tell. My bet is that, given enough downside price pressure, they will. After all, the data does say that recession risks are significant and rising.

Robert Barone, Ph.D. (Georgetown) Formerly: Prof of Finance, bank CEO, Chair of FHLBSF. Currently: Director CSAA Ins., Norcal AAA, Allied Mineral Products. Co-manager: FFIU (NYSE traded) bond fund.

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