Federal Reserve Chairman Signals Change in Policy
Jerome Powell has only been on the job as the new Federal Reserve Chairman since February, but has already created substantial controversy. Powell’s Fed has raised the “Federal Funds” rate 3 times in 6 months. Until recently, the Fed was signalling another rate hike in December and up to 3 more in 2019.
The four additional rate hikes would bring the Fed Funds rates to the target range of 3% to 3.25%. Historically, that level of Fed Funds has neither been restrictive nor recessionary. Yet, 4 more hikes would bring the total for this cycle to 12.
Nevertheless, the rate hikes and stated policy have drawn the ire of many. It’s hardly surprising that the administration would protest. After all, the United States is the largest debtor in the known Universe. Any hike in interest rates produces a huge jump in interest expense.
The United States’ national debt is now $21.8 Trillion and climbing at nearly $1 Trillion a year. (http://www.usdebtclock.org/). For every 1% hike in rates, annual interest expense explodes by $218 Million ($21.8 Trillion X 1%).
Powell’s predecessor, Janet Yellen, raised rates 5 times beginning December, 2015. The first increase ended nearly a decade of “ZIRP”, or “Zero Interest Rate Policy”, following the 2008 financial crisis.
The areas shaded in grey are recessions. Every recession in at least the last half century has been preceded by a Federal Reserve Tightening Cycle.
However, no tightening cycle has either BEGUN at ZERO nor ended at BELOW 3.50%.
Monetary “Neutrality” Just Fell By 1%?
The stated intention of the gradual interest rate hikes is to bring the United States back to “monetary neutrality”. That refers to the level that is neither over stimulating nor restrictive. With “reported” economic activity unusually strong, further continuation of an overly stimulative monetary policy would create its own set of problems, if it hasn’t already. On the other hand, tightening cycles invariably precede financial crises of various scales. See chart below:
In a recent interview on October 2nd, Powell said that the US was still a “long way” from interest rate neutrality. (https://www.cnbc.com/2018/10/03/powell-says-were-a-long-way-from-neutral-on-interest-rates.html).
Powell was insistent that the economy’s strength, tight labor markets and low inflation could easily absorb 4 more hikes to the target range of 3%-3.25%.
Neutrality is generally thought to be in the range of 3%-3.5%, which is also consistent with the historical funds average.
Neutrality, though, is not fixed. Lower inflation allows for lower rates. On the other hand, economic recession or slowdown does, too.
Conversely, if the economy is as robust as has been reported, true neutrality, might even be much higher.
Powell’s 180 Degree Turn
Last Wednesday, in a speech before the New York Economics Club, Powell veered substantially from his former position. He now considers rates to be “just below” neutral. It is unclear whether Powell is signaling that the Federal Reserve will move more slowly, move much less than previously believed, or suspend further rate increases entirely.
Hopefully, Powell has become an avid reader of Markonomics101 and has reviewed some of our recent pieces on the weakening economy. Every Fed Chairman needs to “Be Informed”, Not Misled”. If you would like a little brush up, some great information can be found in these:
“Stock Markets Bracing For Recession?” (https://markonomics101.com/2018/11/21/stock-markets-bracing-for-recession/), and “Oil Prices: A Sign of Oncoming Recession?” (https://markonomics101.com/2018/11/18/crashing-crude-oil-prices-a-sign-of-oncoming-recession/).
Treasury Rates Were Falling BEFORE Powell’s Reversal
While Powell was saying the rates were a “long way” from neutrality, they were peaking or close to it as illustrated by the Slide Show below.
From their recent Peak to current levels, Five Year Treasury Yields fell .25%, 10 Year Yields fell .25% and 30 Yields fell .15%. Crude Oil prices plunged 33% in less than two months. Commodities are now near multi-decade lows. None of this is consistent with an economy that we are told has grown near 4% for the last two quarters and that is at full employment.
As we reported in “Peekaboo Inflation: Now You See It, Now You Don’t”, signs of either inflation or extraordinary economic strength are no where to be found. (https://markonomics101.com/2018/11/05/peekaboo-inflation-now-you-see-it-now-you-dont/)
The Federal Reserve FOLLOWS not LEADS the Markets
The Fed Chairmen may have access to better data than you or I but nobody possess a crystal ball. In fact, the Fed has a reputation for “contrary indicators”: (https://www.nytimes.com/2014/06/18/upshot/federal-reserve-expected-to-reduce-growth-forecast-but-keep-cutting-stimulus.html) and (https://www.forbes.com/sites/advisor/2018/04/25/the-feds-crystal-ball-is-a-little-hazy/#2bfdc8f22159).
With yields falling in bond markets, the Federal Reserve’s new position was inevitable. Just two months earlier, after the September rate hike, markets had priced in 3 to 4 rate hikes through 2020. Not so now.
Powell has made it clear that no more rate hikes will take place next year without supporting economic data. Although, before he did, the market had done that for him. The December hike is no longer a certainty. Traders now place an 80% likelihood of a December hike.
Rather than 2-3 hikes in 2019 as had been expected, the markets suggest there will be only one. No rate hikes are now expected in 2020.
The chart patterns of 5, 10 and 30 Year Treasury rates appear to have made a short term peak. All have made Dome or Rounded Tops and only the Longer Maturity has not fully retraced its breakout.
Falling interest rates can be good news or bad news. But, an “Inverted” Yield Curve is ALWAYS bad news.
Inverted Yield Curve Screams Recession
The “Yield Curve” is one of the most accurate forecasters of either recession or expansion. The term refers to the relationship between a bond’s maturity and its Yield. In general, shorter term debt, such as Treasury Bills, have lower yields than longer term debt. Historically, 30 Year Maturities yield 2-4% more than T-Bills, on average.
A “Steep” Yield Curve means that long rates are much higher than short rates. Banks, and most financial institutions thrive when yield curves are steep. Borrowing at Low short term rates and lending at High long term rates produces great bank profits.
An “Inverted” Yield Curve, however, means that short rates are higher than longer maturity rates. An “Inverted Curve” is neither normal nor typical. It is, however, ominous. An inverted yield curve acts to restrict credit expansion, borrowing and economic growth.
A common measure of yield curve steepness is the spread (in percent) between 10 year and 2 year Treasuries. The history of that spread, over the last 5 years, is illustrated in the chart below: (The more positive the “spread” the steeper the Yield Curve).
The yield differential between the 10 Year and 2 Year Treasuries is close to inverting (going negative). This is a very foreboding corroboration of a weakening economy.
Prior Yield Curve Inversions
An Inverted Treasury Yield Curve preceded the recessions of 1981, 1991, 2000 and 2008. The inversion preceding the “Great Recession” started in early 2006. (https://www.thebalance.com/inverted-yield-curve-3305856)
The DotCom Bust in 2000 triggered a series of Federal Funds rate cuts from 6.50% (in May, 2000) to 1% (in June, 2003). The subsequent housing bubble was fueled by inexpensive mortgages made possible and enabled by accommodative Fed policy. In order to mitigate the damage from the Nasdaq Asset Bubble of the late 1990’s, the Fed simply created a new one in home prices.
Yield curve inversions are rarely the result of free market activity. They are often the result of policy errors which create economic weakness by leaving short term rates above “neutrality”.
Even though the December rate hike appears to be baked into the cake, one more hike may invert the yield curve, especially if economic conditions deteriorate. We may have seen the last interest rate hike for this cycle.
The environment for investing continues heavy with risk and light with return.
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