This is part of an ongoing series of articles published by Johnson Financial Group. This issue is written by Brian Andrew, EVP, Chief Investment Officer.
Last week, Federal Reserve Chairman Jerome Powell gave a speech in which he said that the current level of the Fed Funds interest rate was “just below neutral.” At the beginning of October, he said in an interview that the Fed Funds rate was “a long way” from neutral. So which is it, and why do we care?
We care because we are still in a period where the policies of our central bank, the Federal Reserve, matter a lot to the level of asset prices. Whether we're talking about bond, stock, commodity or currency valuations, asset prices move on Fed policy news.
The “neutral rate” is the level of the Fed Funds interest rate (the rate that other short‐term interest rates are tied to) that creates a balance for the economy, allowing it to run not too hot or cold, but just right. Determining whether we're nearing that rate or not provides information about the future for interest rates and the likelihood that the Fed will overdo it and shut down economic growth too early.
After the Fed Chair's Oct. 3 pronouncement that we were a long way from neutral, the stock market declined by almost 7% in a week. By the end of October, stocks were down 10%, erasing most of this year's gains. Investors interpreted the Chair's comments to mean that the Fed was going to remain on its current path of raising rates at least once a quarter for the next year or more. He also noted that in 2019, each Fed meeting would be accompanied by a press conference, suggesting that rate increases could come even more quickly. (The Fed has eight meetings per year, and in the past they have only raised rates when there's a press conference.)
Higher interest rates put fear into stock investors for two reasons. First, they worry that a higher cost of capital for companies will affect profit margins. Secondly, the discount rate needed to determine future prices will be higher, requiring more earnings to achieve the same level of growth. The Chair's suggestion that the Fed would remain on the same path put fear into stock investors' view of the next year.
Since last week's speech and the “just below” comment, stocks have rallied 6%. Of course the news out of the weekend's global leaders meeting that the U.S. and China would take a 90‐day hiatus from trade tit for tat helped Monday's price action.
Bond investors were also rocked by Mr. Powell's October interview. In the week following, the 2‐year Treasury yield rose by .05% to 2.88%, and within a month it had risen to almost 3%. The 10‐year Treasury yield had risen by almost .2% in the first week! Yields rose as bond investors began to take the Fed at its word. If the neutral rate was a long way off, then the Fed would remain on a path of raising rates several more times in the next year and a half.
Yields, too, have declined since last week's “just below” comment. The 2‐year Treasury yield is now 2.80%, while 10‐years have declined just below 3%. (When bond yields go down, bond prices go up.)
Those five words, just eight weeks apart, accounted for billions in asset price movement. So which is it: Are we just below the Fed's neutral rate or a long way from it?
The Fed's objective is to set interest rates at a level that allows the economy to grow but not overheat. The temperature is measured by the rate of inflation. The Fed wants inflation to be enough to keep prices moving up modestly, but not so much that costs get out of control and crimp spending. Inflation that is too low creates an environment where people begin to believe that future prices will be declining. As a result, they put off purchases, which in turn slows the economy.
Of course it's impossible for the Fed to get it just right because it is dealing with a $20 trillion U.S. economy in a globalized world. And sometimes the Fed gets it wrong altogether. Also, remember that the Fed Chair is new this year and still learning how to carefully get the message out. Some believe that the comments made during the interview in October were off the cuff, and he didn't realize the impact it would have until he saw it play out in the markets. The speech last week was intentionally made to walk back his October comments.
There is no doubt that higher interest rates are having a slowing effect on the economy. If you look at the housing market, home sales and permits for new construction are down considerably since the first of the year. Because of higher interest rates, the cost of a $200,000 house is up over 10% since the beginning of the year if 80% of the purchase price is borrowed.
Companies' interest expense has also risen. While debt ratios are better than we've seen in the past, the higher cost of that debt will eventually cause cash flow and profit margin problems, something stock investors will continue to wrestle with.
For the Fed's part, they will monitor economic and consumer growth data very carefully going forward so as not to raise rates too far. Their challenge is that while economic growth has accelerated to almost twice the 10‐year average rate, inflation remains just below the target. Last week, the core rate of inflation was reportedly 1.8% – the target is 2%. It is possible that the dynamics of technology and transition from boomers to millennials is preventing inflation from moving higher despite better growth.
We believe the lack of inflation pressure will give the Fed pause as we move into 2019. In the meantime, asset prices will continue to be more closely tied to monetary (i.e., interest rate) policy than we'd like. This means that for now, parsing what the Fed says will remain more than sport. It will have a bearing on how we invest.
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