On Friday, November 2nd, the Dow Jones Industrials ended down 110 points in a wild day in which the index swung over 500 points from its intraday high to its intraday low. This occurred despite one of the most stellar employment reports in recent memory, a report that raised hopes that the economy would continue to grow in the 3% range, and a report that put smiles on the faces of retailers countrywide with the holiday shopping season set to begin. At the same time, interest rates were uncharacteristically volatile with the 10 year U.S. Treasury yield rising to 3.22% from a 3.14% level the previous day.
It’s the Fed
Normally, one would expect the equity indexes to rise when there is stellar economic news. But, today, good economic news appears to be frighten Wall Street. While the business channels continue to emphasize the tariff and trade issues, which are somewhat impactful, the underlying issue here is really interest rates. For 2019, markets had been pricing in only two Fed interest rate hikes despite their public stance that they would be raising rates past “neutral.” Given the current Fed definition of “neutral as a 3% Federal Funds rate (the rate banks pay each other for overnight reserve borrowing), that means at least four, and more likely five, rate increases from current levels (the current Fed Funds rate is between 2% and 2.25%). On October 3rd, Fed Chair Jerome Powell, in a public appearance, stated that “we’re a long way from neutral at this point.” That view has been reinforced by other Fed Governors. So, it is clear the Fed intends to continue its rate raising regime.
As an aside, let’s also not forget that the Fed is draining $50 billion/month from public liquidity by allowing maturities in its portfolio to run off, making it necessary for the public to absorb, not only those run offs, but also the unusually large Treasury and Agency financing needs from uncharacteristically high Federal deficits at a time of full employment. Recent Treasury auctions have been “sloppy” (not well bid compared to historical norms).
Prior to the employment report, markets believed that the Fed would change its mind given the 10% downdraft in equities in October and the deceleration in the hard-economic data in Q3, and that, by the time they hiked this December and twice more in 2019, the economy would have decelerated to a low enough level that further hikes would be unnecessary.
But, all that changed on November 2nd. The robust employment report, along with some easing of concerns regarding how tariffs may negatively impact economic growth, have made the market reconsider how far up the Fed may actually take interest rates.
The Fed’s Track Record
The Fed has a very poor track record when it comes to forecasting recessions. Going all the way back to 1969, for each year in which a recession occurred, the Fed’s economists consistently forecast positive economic growth. Then, of course, we have the infamous Ben Bernanke statement that the housing meltdown had been contained as well as a similar Greenspan comment relating to the dot.com bubble. Let’s also be cognizant of the fact that, of the 13 Fed rate raising cycles in the post-WWII era, 10 have resulted in recession.
Monetary policy is clearly very powerful, but it acts on the economy differently in each cycle. Economists like to say that monetary policy acts with a “long and variable lag,” meaning that no one really has a handle on what the impact will actually be, nor when it is likely to occur. Given the profound changes to the economy over the past 10 years, its reaction function to rising interest rates is surely much different than it has been in the past.
Main Street vs. Wall Street
The employment report also revealed that, year over year, wage rates rose from 2.8% in September to 3.1% in October. Over just the past three months, wages have risen at a 3.4% annual rate, up from as low as 2.5% earlier this year. That appears to be good news for Main Street. But Wall Street has a different view: 1) Given the economic deceleration in the hard data of late, rising wages may eat into corporate profit margins; 2) As long as the growth in wages, a lagging economic indicator, has a “3” handle, it is likely that the Fed won’t have much choice but to continue its rate hiking path.
The Corporate Debt Burden
Markets also have other reasons for concern. Corporate America has a record amount of debt, much of it coming due over the next five years. For historical perspective, in 2009, only about 32% of investment grade corporate bonds and notes were rated BBB. Today, that percentage stands at 50%. In the next recession, then, one can expect an extraordinarily large number of companies to be downgraded to junk status.
In 2018, about $400 billion of corporate debt has or will come due. As the year has worn on, especially beginning in Q3, interest rates escalated, making it more expensive to refinance that debt. (Similarly, mortgage rates have risen for households, and we know what a negative that has been for housing.) But, here is the kicker: the next four years will have significantly higher financing needs. 2019: $560 billion; 2020 and 2021: $1 trillion each; 2022: nearly $1.1 trillion. At today’s current interest rates, the total interest bill paid by corporations to refinance their maturing debt will be 2.2 times higher than the interest they had to pay on that debt in 2017. And higher yet if rates continue upward, as expected. For example, if rates rise another 100 basis points (1 percentage point), very likely under the current Fed scenario, then the interest bill will be three times what it was just a year ago. That will either squeeze margins (Wall Street won’t like that) or corporations will have to raise prices (i.e., inflation) causing more Fed reaction (Wall Street won’t like that either!).
There are three possible scenarios:
• The economy weakens enough for the Fed to stop raising short-term interest rates. This scenario has a low probability a) because of the apparent strength in the economy, especially in the labor market, and/or b) because it appears that cost-push inflation (the wage indicator) is just now emerging;
• The Fed engineers a soft-landing. That means that they take their foot off the brakes just at the right time. Given the Fed’s past track record (Three soft landings in 13 rate raising cycles), and because no one really knows the long and variable lag time between changes in monetary policy and the resultant economic impact, the probability of this occurring is also low;
• The high probability scenario is that, due to the continuing strength in the employment market and the emergence of cost-push inflation (not helped by the tariff issue which, in and of themselves, cause inflation through an increase in the cost of imported goods), the Fed pushes rates up too far resulting in a recession.
With the latest employment report, recession should be off the table, at least an imminent one. Nevertheless, from their current and prior rhetoric, it appears that Chair Powell and his colleagues aren’t as sympathetic to equity market downdrafts as were his previous three predecessors. Given the Fed’s track record in both forecasting recessions and in raising rates too high, it isn’t any wonder why the equity markets have been so volatile and now appear to have a downward bias.
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Unconstrained Medium-Term Fixed Income ETF (FFIU).
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.