After trading in a narrow range (2.80%-3.10%) for much of Q2 and Q3, interest rates broke wildly to the upside as Q4 began. The real wonder was not the rise in rates, but why they stayed so benign for so long, especially in the face of record low unemployment and what seems to be a stock market that won’t quit. Rising rates now pose a problem for financial markets as they surely will decelerate economic growth, a theme I have discussed over the past few months.
The official (U3) unemployment rate fell to 3.7%, a level not seen since 1969. It should be noted here, however, that this U3 and the unemployment rate of 50 years ago are not the same, as this concept has been refined and redefined over the years, especially in the 1990s. The broader concept of unemployment (U6) actually ticked up to 7.5% from 7.4%, but both the stock and bond market ignored that fact, and while rates spiked, equity prices tumbled.
The number of new jobs created (134,000) disappointed Wall Street (consensus was for 185,000) which had been bulled up by the 230,000 ADP print two days earlier. Likely at play here was the seasonal adjustment issue discussed in my last blog. Wall Street was encouraged by the nearly 90,000 jobs that were added back to the July and August data, but once again, we should be cautious about how to interpret those two new data points, as all of the eight months of 2018 data actually changed with the concurrent seasonal adjustment process, but BLS only reports the last two (saying that reporting all of the changes would only confuse the public!).
A Tightening Fed
Nevertheless, the market interpreted the fall in the unemployment rate as a sign that the economy could be overheating, and, given recent Federal Reserve words and actions (see below), jacked up interest rates in a spasm similar to the 2013 “taper tantrum,” the bond market up-spike to then Chairman Bernanke’s announcement that the Fed would be gradually removing monetary accommodation.
Today’s Fed Chair, Jerome Powell, added fuel to this fire when he made it clear in early October that he views the Fed’s current policy as still accommodative, and that the Fed may go past what they consider to be a “neutral” Fed Funds rate. What really scared Wall Street was his comment that “we’re a long way from neutral at this point,” and indicated that they were likely to “overshoot” neutral. The Fed has made it clear that “neutral” is a Fed Funds rate of 3%, so from its current position (Fed Funds = 2.00% to 2.25%), if the Fed is going to overshoot, that would mean at least four more quarter point hikes. Neither the stock nor bond markets were priced for this scenario; thus, the recent reactions.
Interest rates are also quite sensitive to inflation expectations. Amazon’s recently announced $15 minimum hourly wage, coming right before the year end retail holiday shopping season, should send wages up significantly in Q4, as other retailers compete for the dwindling number of warm bodies still looking for work. The data emanating from the employment report show an uptick in wages to a 3.6% annualized growth rate over the past quarter. The wage index used here is a lagging indicator, and I suspect that inflation is somewhat hotter than this indicates. Nonetheless, at a 3.6% rate, and likely to go higher, the Fed will have little choice but to continue to put its foot on the brakes, perhaps braking harder than the markets currently anticipate.
In my last blog, I discussed the fact that this is the most leveraged U.S. (and world) in history. Even a Republican White House and Congress has gone crazy on deficit spending right at or near the cycle’s peak (when they are supposed to be running surpluses). We have come from a mortgage leveraged world in ’08 to a world of corporate leverage where 40%-50% of the $6 trillion corporate debt (up from $700 billion in 2009) is rated BBB. With huge corporate refinancing calendars over the next few years, if the economy slows and the cost of refinancing that debt rises, a significant number of rating downgrades to “junk” status (less than BBB-) is inevitable. What happens to those companies already rated as junk? Think: possible defaults!
Recession Probability “Not Elevated”
There is no reason to fear an oncoming recession, at least according to Mr. Powell. At the same conference where he discussed the “neutral” rate, he also said: “There’s no reason to think that the probability of a recession in the next year or two is at all elevated.” Just to put this comment into context, Ben Bernanke and Alan Greenspan made similar comments, with Greenspan’s coming just three months prior to the 2001 recession, and Bernanke’s after the Great Recession had already begun in 2008. The fact is, the Fed has never forecast a recession. And, they really can’t do so publicly. Just imagine market reaction if a Fed Chair were to actually forecast a recession. Even if the Fed or its Chair suspected such, they couldn’t say it for fear of dramatic market action. On the other hand, if today’s Fed suspected a high probability of a recession, it would currently be easing or neutral, not tightening policy. So, it is fair to say that Powell and Company really don’t see a recession anytime soon.
Accelerating or Decelerating
It is one thing for the current interest rate spike and prospective higher yields to occur in an accelerating economy which may be able to weather such increases. It is another thing altogether if the economy is decelerating. If accelerating, then tighter monetary policy is appropriate. If not….
Even before the recent spike in rates, the housing sector was weakening. For the last couple of years, weak housing data were blamed on lack of supply, and Wall Street ignored the weak data. But, now, there is growing evidence that demand is weakening as rising rates, even before the latest spike, have cut significantly into housing affordability. We also see that building permit applications weakened, sales of existing homes were flat to down, and traffic at the major home builders has been floundering.
No one appears to be much concerned about the rise in oil prices. Sanctions will be imposed on Iranian oil exports in early November, and oil exports from Venezuela have tanked. It appears that the Saudis and Russians combined do not have the excess capacity to fill the void. And while the U.S. appears to have the oil, it doesn’t have the infrastructure to move it (pipelines) and distill it (refineries). Significantly rising gasoline prices will act as a large tax on U.S. consumers in Q4 as most U.S. consumers have little choice but to pay the higher cost and forego other discretionary purchases.
My last few blogs discussed emerging market (EM) issues, slower growth in China, and the fact that synchronized world growth is clearly in the rear-view mirror. Lately, even Goldman Sachs’ economists see decelerating growth, as a recent economics piece was titled “Still Growing, But Slowing.”
Expect Market Volatility to Return
It appears that we have come to a critical crossroads: If the economy is decelerating but the Fed doesn’t see it, which would be the logical conclusion from the FOMC minutes and the Chairman’s remarks, then the danger is that, as they have consistently done in the post-WWII modern era, they will over-tighten with recessionary consequences. No wonder volatility has returned to both stock and bond markets!
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.