Broker Check

The Fed, the Yield Curve and the Economy

| August 20, 2019

The first rate cut since the financial crisis

On July 31, the Federal Reserve reduced the fed funds rate by ¼% to 2.00-2.25%. It was the first rate cut since the financial crisis.

Going forward, guidance was vague. While Powell left the door open to at least one more cut, it’s not assured.

The rate cut wasn’t in response to a faltering economy. The Fed said, “Economic activity has been rising at a moderate rate.”[1]

Yet, in an 8-2 decision (the dissenters wanted to keep rates unchanged), the Fed said it cut in order to “insure against downside risks from weak global growth and trade policy uncertainty.”

Falling interest rates in 2001 and 2008 failed to stem the outflow out of stocks as economic growth faltered. However, during the mid-1980s, mid-1990s, and late 1990s, rate cuts by the Fed, coupled with economic growth, fueled market gains.

The common denominator that determined the direction of the market was the direction of the economy. The economy and corporate profits have historically been the most important factors that determine the long-term direction of stocks.

Steady as she goes

Gross domestic product, which is the broadest measure of economic activity, slowed from Q1’s 3.1% annualized pace to 2.1% in Q2 (U.S. BEA).

While soft business spending is likely a reaction to the global slowdown and uncertainty caused by trade tensions, consumer spending rebounded sharply.

Job growth is solid. First-time claims for unemployment compensation are low, the unemployment rate is below 4%, and consumer confidence is strong.

If we average Q1 and Q2, growth is a respectable 2.6% as we head into the second half of the year.

Maybe, just maybe, consumers aren’t paying attention to what’s happening on the trade front and are much more focused on their own situation.

Tariff Talk & Yield Curve Inversion

The day after the Fed reduced rates, President Trump tweeted he would impose a 10% increase on the $325 billion of remaining Chinese imports, sending the markets fleeing to the safety of Treasuries. Thus far tariffs have had a modest negative impact on GDP, and while additional tariffs (some of which are scheduled to be added in December) appear manageable, they will certainly add pressure on the Fed to reduce rates further at future policy meetings.

Source: Goldman Sachs Global Investment Research and GSAM. As of August 9, 2019.

On August 14th, the yield on the 10-year Treasury dropped below the yield on the 2-year Treasury. When this occurs, it is referred to as an “inverted yield curve.”

The media has been quick to report that yield curve inversions have historically been associated with an increased likelihood of an economic recession.

Over the previous 5 recessions, on average a recession began 21 months following the inversion of the 10-year / 2-year Treasury yield with the average S&P 500 return 24.5% over that same period.

The media frenzy implies an imminent market collapse but we should recognize if a recession is coming, there is likely going to be a lag before the recession actually begins and equity markets could still perform positively in the interim. Perhaps the Treasury yield inversion is also not the only indicator we should be observing.

As mentioned above, the health of the economy is important for sustained growth in the markets. The main composite of indicators that measures changes in the future direction of the economy is the Leading Index.

The chart[2] below depicts Treasury yield inversions (when the red line dips below the black horizontal bar) against the Leading Index. Recessions are shown by the vertical shaded areas (often when the Leading Index drops below the black horizontal bar). Note that inversions shown tend to occur just prior to or coincident with the Leading Index dropping. This reinforces our belief that we should also be monitoring the health of the economy.

Domestic manufacturing activity (one of the indicators in the Leading Index) has slowed to 50.4 in July (a score >50 is considered expansionary), the slowest in 10 years. Globally manufacturing is not as sanguine with manufacturing contracting with a score of 49.5 in July[3]. It’s noteworthy that this is partially a function of the protracted uncertainty created by the trade war.

Yet U.S. unemployment remains at a 50-year low with wages having grown steadily at 5.1% for the first half of this year[4], inflation is low, consumer confidence is high, and we have an accommodative Fed in place.

We anticipate more volatility as the market digests the likelihood of different outcomes of tariff plans and Fed action. We design portfolios in anticipation of volatility, not in response to it. This entails a thoughtful review of client portfolios vis-à-vis their tolerance for risk, time horizon and portfolio income needs. A process we believe all investors will benefit from.