Based on the recent direction of the U.S. economy and the drop in Treasury bond yields to six-month lows, it would appear that the Federal Reserve may have been a little too hasty in raising interest rates and ending monetary accommodation. So how will the markets – both stocks and bonds – react if the Fed has to swallow its pride and need to stuff the genie back in the bottle?
As we know, since Donald Trump was elected last November, the Fed has raised the federal funds rate twice, plus promised at least two more increases by the end of this year. At the same time, it’s also said that it plans to start trimming its massive $4.5 trillion securities portfolio before year-end. All of that action has been predicated on the economy growing and potentially over-heating – i.e., causing too much inflation – under President Trump’s stimulative policies, including tax cuts, deregulation and repealing and replacing Obamacare.
But what happens if those assumptions don’t actually become a reality, which is what seems to be happening right now? Will the Fed suddenly start lowering interest rates again, or at least put off its plans for future rate increases? And will it also put on hold its balance sheet reduction plan?
And how will the markets react to that, now that the Fed has laid the foundation for a less accommodative policy?
Unlike under President Obama, when the Fed gave the White House an enormous canyon of error before even thinking about tightening monetary policy, the Fed since last November has shown no reluctance to raising interest rates based on assumptions that don’t appear to be working out as planned.
The biggest hint that something might be off was last month’s employment report, which came in much weaker than expected, especially compared to the previous two months. To refresh your memory, the economy added just 98,000 nonfarm jobs in March, less than half of February’s total of 219,000 – which was itself downwardly revised – and well below the consensus Street forecast of a 175,000 gain.
Reports released since then show a similar weakening economy. The ISM’s two widely watched indexes both came in well below expectations in March. The non-manufacturing index, which covers most of the economy, fell more than two points to a five-month low of 55.2 from 57.6, while the manufacturing index fell a half-point to 57.2. Motor vehicle sales slowed unexpectedly last month.
The annual sales rate fell to 16.6 million vehicles, down a full one million from February’s pace and well below expectations of more than 17 million. Then last week the Commerce Department reported that retail sales fell 0.2% in March, the second straight monthly decline, as February’s 0.1% increase was downwardly revised to a 0.3% drop.
Then there’s inflation. After blowing past 2%, the Fed’s threshold for raising interest rates, in February, inflationary pressures have since eased. The Consumer Price Index fell 0.3% in March, the steepest drop in more than two years, while the core barometer, excluding food and energy prices, fell 0.1%, its first monthly decline since January 2010. Producer prices were similarly lower, falling 0.1%, the first decline since August, while the core rate was unchanged.
Over the weekend, the New York Times carried a story in which several top bankers said many of their business customers have started to hold off on their borrowing and investment plans until they become more convinced that President Trump can really get his economic agenda passed.
“They all want to believe that there is more growth ahead, but they need to see something out there before they act,” Wells Fargo’s chief financial officer John Shrewsberry said.
“If this continues, it is definitely concerning,” Leo Mourelatos, a risk analyst at BMI Research, told the Times. “It would signal that the U.S. economy is much weaker than the current consensus.”
At the same time, we’ve had a series of international confrontations – with Syria, Russia, North Korea and terrorists in Afghanistan – that have made investors nervous.
All of this has resulted in the lowest 10-year Treasury bond yield in six months. Last week the yield on the benchmark note fell 15 basis points to 2.23%, its lowest level since last November.
Yet there was Fed Chair Janet Yellen last week telling an audience at the University of Michigan that the era of accommodative monetary policy has largely come to an end. Did she not know about any of the aforementioned news?
The fact remains that investor exuberance and anticipation aside, we simply don’t know if the Trump agenda will become reality and boost the economy as intended. Its first failed crack at health care isn’t exactly a positive harbinger.
Until then, the Fed should have relied on its famous patience and waited before doing anything. If it could wait eight years under Obama for the economy to grow again, why can’t it grant at least a little of that same latitude to Trump?
It will be interesting to see what happens if the Fed has to loosen policy again after telling everyone it’s going to do the opposite. The markets may not react so positively this time around
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INO.com Contributor - Fed & Interest Rates
Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.