The Rate Cut the Economy Doesn’t Need — but the Markets Do
By Randall W. Forsyth
Photograph by Andrew Harrer/Bloomberg
“Who are you going to believe, me or your own eyes?” That is a quote at the core of Marxist ideology from the most eminent of its authors, Groucho.
And that is a question that the Federal Open Market Committee must confront when it gathers on Tuesday and Wednesday for its highly anticipated meeting. Expectations run high that the Federal Reserve’s policy-setting panel will signal it is ready to lower its key policy interest rate, if not at this gathering, then at the next one, at the end of July.
What seems out of sync with the rising calls for rate reductions is that the U.S. economy and stock market both seem to be doing better than OK, thank you, as the expansion and bull market celebrate their 10th anniversaries. Unemployment is around the lowest level in a half-century. The worst thing seems to be that inflation continues to run slightly below the Fed’s 2% target, a problem that might strike some as similar to being too rich or too thin.
Nevertheless, the federal-funds futures market is pricing in three 25-basis-point reductions in the central bank’s target, from the current 2.25% to 2.50% range, by as soon as year end. (A basis point is 1/100th of a percentage point.) A move is unlikely at this coming week’s confab, although the futures market puts a nontrivial 25.8% chance for a reduction. In contrast, there’s an overwhelming 86.4% probability of a cut at the July 30-31 FOMC meeting, according to CME Group’s FedWatch site. Futures traders have priced in additional 25-basis-point decreases at the Sept. 17-18 and Dec. 10-11 meetings.
Yet these potential Fed rate drops would come while the economy is growing at roughly its long-term trend, which admittedly is a downshift from last year’s tax-cut-boosted 2.9% pace. That said, global growth does face a clear and present danger from tariffs and trade wars, which already are exerting a drag on corporate outlooks. But how much can reductions in already-low interest rates do to offset the contractionary forces on trade?
Those arguing for more monetary accommodation contend that the economic data provide a rear-view mirror image of what has happened. Forward-looking indicators, notably the yield curve, are flashing warning lights that have signaled past slowdowns and should be heeded. Too-low inflation also can become embedded in consumer and business expectations, which then persistently hurt growth, as Japan has demonstrated.
The Fed insists that its policy decisions are data-dependent. The data look good, even if some recent numbers don’t look great, including the disappointing 75,000 increase in nonfarm payrolls in May, about 100,000 shy of forecasts. But a stronger-than-expected rise in May retail sales of 0.5%, plus upward revisions in previous months, has gross domestic product on track to expand at a 2.1% annual clip in the current quarter, according to the Atlanta Fed’s GDPNow tracker, up sharply from its previous estimate of 1.4%, made on June 7.
That would be below the first quarter’s preliminary GDP growth of 3.1%, but the underlying components of the data actually seem to be improving.
Real personal-consumption expenditures, which account for more than two-thirds of the economy, are climbing at a 3.9% annual pace in the current quarter, the Atlanta Fed estimates, an upward revision from 3.2% previously and triple the 1.3% in the supposedly sterling first quarter.
In its previous Summary of Economic Projections, released at the March 19-20 FOMC meeting, the panel’s central forecast for GDP growth this year was 1.9% to 2.2%, a shade above its longer-run estimate of 1.8% to 2%. So the economy would appear to be expanding in line with the Fed’s expectations.
The job market doesn’t seem to be laboring. Despite the smaller gain in payrolls, the 3.6% unemployment rate harkens back to the glory days of the Apollo moon landing and Woodstock. The jobless rate is a lagging indicator, but new claims for unemployment insurance, a leading indicator, also hover near half-century lows. Other surveys find more job openings than applicants, and small businesses having trouble finding qualified employees. Average hourly earnings are growing at a better-than-3% pace. And that might understate wage gains, as prime-age workers make up a higher proportion of the workforce and higher-paid baby boomers retire.
Inflation seems to be the Fed’s main bugaboo, as it remains persistently below the 2% the solons view as the right number. Their favorite measure, the “core” personal consumption deflator, which excludes volatile food and energy prices, is running at just 1.5%. But “trimmed mean” measures of inflation—which throw out aberrant inputs that Fed Chairman Jerome Powell has called “transitory”—are trending much closer to the 2% target.
The Fed also has emphasized the trimmed-mean personal-consumption expenditures indicator lately, which J.P. Morgan economists find useful in predicting PCE inflation over the course of an economic cycle. And those expenditures are remaining around 2%, suggesting no great shortfall in inflation. That has been corroborated by other measures that attempt to reduce the influence of outlier prices. The Cleveland Fed’s mean consumer-price index has shown no easing in inflation, while its median consumer-price index suggests an upward trend, in contrast to the core CPI’s deceleration.
That contrasts with early 2017, when all three CPI measures fell sharply.
One alternative measure of inflation that has shown distinct moderation is the Economic Cycle Research Institute’s U.S. Future Inflation Gauge, which this column highlighted last year to suggest that the Fed might be overdoing rate increases. The institute suggests this has turned down before rate cuts were begun in past cycles.
But the most widely cited indicator pointing to Fed rate cuts has been the bond market, and the yield curve, in particular. The three-month Treasury bill’s yield has remained above that of the 10-year note for five weeks—historically a harbinger of economic downturns. The decline in bond yields has been global and might largely be attributable to factors outside the Fed’s control, notably trade frictions.
Indeed, nearly $12 trillion in negative-yielding bonds is outstanding, according to Deutsche Bank, with the 10-year German Bund (the benchmark for European bonds) trading at a record minus 25 basis points. That surely exerts a gravitational pull on U.S. bond yields. They stand out globally among top-grade securities, with the 10-year Treasury at 2.08%.
That’s below the 2.18% from a three-month T-bill and even further from the 2.25% low end of the Fed’s target range for overnight fed funds. The implication is that the central bank is holding up the fed-funds rate in the face of market forces pulling down other rates. (For more on this, see this week’s Economy column.)
But there might be another factor behind the near-unanimous calls for the central bank to trim rates. Almost every asset class—stock, bonds, and real estate—is richly priced, compared with rates on cash equivalents. Lowering money-market rates would make asset prices seem less inflated. And that’s the one sort of inflation nobody seems worried about being too high.
There seems to be a lot of confidence—or possibly complacency—that the Fed will fulfill market expectations and signal the rate reductions predicted by fed-funds futures. Those sentiments are borne out in another corner of the derivatives market, futures on the VIX index, the so-called fear gauge measuring volatility on the S&P 500index.
There is a high speculative short position in VIX futures, according to the J.P. Morgan global markets strategy group, led by Nikolaos Panigirtzoglou. Those are bets on continued low volatility; in other words, wagers that nothing will go wrong. The last times such bullish sentiment was apparent were in January and September 2018, when the best-laid plans of low-volatility bettors went spectacularly awry.
As a result, the equity market could be vulnerable to a “more cautious and patient Fed,” which could trigger a correction, the bank’s strategists write in a client note. Even a truce in the U.S.-China trade war would be viewed as only a neutral outcome at the next big market event, the Group of 20 meeting in Japan on June 28 and 29, while a breakdown in trade talks would be a negative, they add.
Complacency is evident elsewhere in the equity market, which the JPM team figures is pricing in a mere 6% chance of a recession, in contrast to the 60% probability that they reckon is implied by the five-year Treasury note’s yield of just 1.83%, well below the three-month T-bill’s 2.18%.
The consensus earnings estimate of $167 for the S&P 500 companies is far from the contraction likely in a recession, they add, and 3% above the benchmark index’s tax-cut inflated profits last year.
The markets are likely to be caught in a tug of war between the positives from falling bond yields and the negatives from sliding earnings estimates, says Cliff Noreen, head of global investment strategy at MassMutual, the big insurer. Look for trade and tariff issues to come up in earnings warnings, as it has at Broadcom(ticker: AVGO), which slashed 2019 revenue guidance, owing to a broad-based slowdown in chip demand and export restrictions.
Strategists with year-end S&P 500 targets of 3000 or higher (just a 4% gain from Friday’s close of 2886.96) are implying a relatively rich 18 price/earnings ratio, facilitated by low bond yields.
Meanwhile, initial public offerings are partying like it’s 1999 (see Tech Trader). No wonder Wall Street hopes that the Fed spikes the punch bowl.
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