There were three big takeaways from March’s FOMC meeting:
- The economic projections were revised down slightly.
- The Dot Plot2 of Fed interest rate expectations was downgraded to no hikes in 2019 from two hikes previously.
- The committee proffered a timeline for slowing and then ending the balance sheet roll-off.
Other things being equal, we concede that through the mathematics of discounting, lower interest rates should be supportive of stocks. Unfortunately, “all things being equal” almost never applies in real life. Monetary policy is part of a feedback loop. The Fed isn’t changing its interest rate outlook in isolation. Presumably, data from both the real economy and current financial conditions are informing their views.
Dot Plot Dilemma
In revising the Dot Plot from two to zero hikes this year, we have to ask – what does the Fed see on the horizon? A sharp slowdown in the US and/or global economy? Stubbornly low and decelerating inflation? Fiscal, trade, or geopolitical headwinds? Some combination of all three? A sufficiently broad interpretation allows FOMC members to shoehorn any of these factors into their dual mandate of full employment and price stability.
The point is, the Fed is becoming more accommodative for a reason. It isn’t enough for investors to simply look at the discount rate for financial assets. We have to consider the trajectory of the global economy, which is a proxy for the stream of future cash flows that is being discounted. Hypothetically speaking, if global growth and earnings expectations were collapsing, equities would get hammered despite lower rates. We fear that bullish investors may be overly focused on the fact that the Fed has paused – as opposed to why the Fed has paused.
Less Restrictive vs. Outright Dovish
Given the feedback loop, another possibility exists as well – that even lower interest rates will reinvigorate economic growth. This is the bullish scenario where the cash flows improve while they are discounted at a lower rate. Alas, this outcome seems unlikely, as the US economy is already running close to capacity (as defined by a positive output gap4) and is fairly limited in terms of supply-side constraints on labor force growth and productivity. Perhaps the key lesson of central banking post-Global Financial Crisis is that super-accommodative monetary policy can mitigate the worst-case scenario, but has had very limited success in boosting growth – the classic problem of pushing on a string.
We believe it is too early for a definitive reading of the Fed’s tea leaves. The key distinction lies in the framing of monetary policy. That is, a “less restrictive” Fed, one that is merely pausing, should provide support for risk assets. This was clearly the message in late December and early January when stocks staged a strong rebound. Conversely, an “outright dovish” message from the Fed (“interest rate cuts may be nigh…”) should be a warning sign to investors. Perhaps the market is coming around to our more cautious take on the Fed’s stance. As of this writing, the S&P 500® has gone effectively nowhere since the FOMC meeting, as investors are split between the support provided by a more accommodative Fed and the weaker outlook that support portends.
Yield Curve Hysteria
Speaking of warning signs, the slope of the yield curve has many investors freaking out again. Since the Fed’s dovish dip from two forecasted hikes this year to none, the market has begun pricing in potential interest rate cuts in 2019 – with a probability of 75% before year-end (data as of 3/27/19). As longer-term rates are just an expectation of future short-term rates, this has caused short-to-intermediate term yields to plunge in the 2–7 year range of the yield curve. As a result, the US yield curve is now inverted between the 6-month bill and the 10-year bond. Given the yield curve’s historical success in forecasting recessions, many equity investors are taking notice.
So what are we to make of the latest round of yield curve hysteria? Let’s start by saying that while things do change, any variable that has had the recession forecasting accuracy of the yield curve should be taken quite seriously. It should also be noted that the predictive prowess of the yield curve is not some random relationship. There are legitimate reasons why the slope of the curve is important – not least of which is that it’s a broad proxy for the tightness of financial conditions.
Banks are unlikely to extend a lot of credit to consumers and businesses knowing they’re collecting less income on their longer-term loans than they’re paying out on their shorter-term deposits. We’d also be remiss if we didn’t highlight the expectations component. Today, the yield curve is so universally known as a predictor of future recessions that businesses and consumers may pull back on credit demand (thinking a recession is coming) in spite of the current strength of the economy. Investors who dismiss the yield curve signal may well be whistling past the graveyard.
However, it is fair to say that in an era of zero/negative interest rates and $17+ trillion in global quantitative easing,5 the predictive power of the yield curve may be somewhat impaired. To some degree, longer-term US yields are have been artificially suppressed by central bank purchases and negative interest rates in Europe and Japan – where capital flows into the US bond market further suppress US yields. Maybe parts of the US yield curve no longer represent market forces foreshadowing recession, but instead are simply a byproduct of central bank manipulation? Maybe.
With respect to the yield curve, the crux of the issue seems to be whether the slope is more cause or effect. Will the inverted curve limit credit expansion? Or is the downward slope just an indication that investors believe the economy is slowing?
We don’t have all the answers (or maybe any of them), but these events change our asset class outlook very little. We remain cautiously optimistic that the Fed is pausing, but not in full retreat. And we don’t believe an inversion of the yield curve is a perfect predictor of an oncoming recession. However, these combined developments argue for more conservative portfolio positioning.
We continue to see the risks as asymmetrically skewed this late in the cycle. We believe equities and credit sectors of the bond market can grind higher in a scenario where the global economy is naturally slowing toward longer term potential GDP rates, but not falling into recession. However, this scenario still implies somewhat muted returns at current price, yield, and valuation levels. On the other hand, if the global deceleration morphs into recession, we see much greater pain ahead for investors. Our caution reflects the fact that there is more downside to being wrong (recession) than there is upside to being right (no recession).
2 The Fed Dot Plot, published after each meeting of the Federal Open Market Committee (FOMC), shows the interest rate projections of the 12 committee members.
3 The S&P (Standard & Poor’s) 500 Index is an index of 500 stocks often used to represent the US stock market. You cannot invest directly in an index.
4 Output gap refers to the difference between actual gross domestic product (GDP) and potential GDP.
5 Quantitative easing refers to monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
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