March 2019 – Monthly Commentary
Investor perception has turned with regard to fundamental economic activity and the pricing of interest rates. The Federal Reserve has targeted the Fed Funds rate at approximately 2.42% while the yield on the 5-year Treasury note is 2.30%. That the 5-year note yields less than the overnight rate is known as an inversion and typically a sign of an unhealthy market. When the yield curve inverts, it indicates that investors expect the average overnight rate for that term will be below that of the current overnight rate. In essence, investors are locking in the rate for 5 years before the Fed cuts rates. We believe that given current economic fundamentals, the thought that the Fed will lower rates is ridiculous. And yet one well-respected professional investor wondered if the Fed would be forced to cut interest rates to meet the expectations of investors. Given the degree of confusion the Fed has created, the question, which would normally be considered absurd, is a valid concern. In addressing that concern, the ultra-dovish Minneapolis Fed President, Neel Kashkari, said that he didn’t believe that an immediate rate cut is justified. Of course it isn’t justified! Rates have fallen because the Fed is buying bonds and plans to cease balance sheet runoff in May, meaning they will be buying even more bonds. It’s foolish to look to the bond market as an economic indicator because the Fed is manipulating the indicator. They could look at the unemployment rate which stand at 3.8%, only 0.1% higher than the low touched this century, or the 7 million jobs that are available but remain unfilled. Similarly, for the week ending March 30, initial claims for unemployment insurance totaled 202,000, the lowest level since 1969. To put that into perspective, the workforce in 1969 according to the Federal Reserve of St. Louis was approximately 81 million workers. As of February the workforce totaled more than 163 million.
But employment has historically been a lagging indicator and perhaps those unfilled jobs will go away with a recession. Counter to that argument is the S&P 500 which has recovered from the hedge fund dump that happened in December and now stands just below its all-time high.
Since the dovish about face in December, the clear beneficiaries are the rate sensitive industries. After nearly a year of disappointing sales, auto sales in March registered an annualized 17.5 million units, well above consensus expectations. Similarly, since the beginning of the year mortgage applications have skyrocketed with purchases climbing nearly 10% and refinancing jumping an eye popping 58% year-over-year, respectively.
Much has been written about how much of a role Donald Trump played in the Fed’s policy reversal with most concluding that Chairman Powell caved to Presidential pressure. The Fed board members have sought to downplay the President’s role, but that has done little to change consensus thinking. What seems obvious is that Trump believes that his cajoling was effective and that the rally in stock prices this year is to his credit. What also seems clear is that he believes cutting interest rates would be even better. The “more is better” mentality seems to now extend beyond browbeating Powell, to stocking the board with Governors sympathetic to Trump’s wishes. For the most part, the Federal Reserve Board has been above politics and the Fed Chairmen have avoided having politics play a role in their decision making. To change that policy risks damaging the economy for years or even decades to come. The reason why the Fed tightens monetary policy when activity is robust and eases policy when activity slows is to attempt to balance employment and inflation with steady growth. At this stage of the economic cycle a 3.00% Fed Funds rate is arguably a sensible neutral rate. Instead, Trump is advocating cutting interest rates and reintroducing bond buying in an attempt to reaccelerate growth. As a mature economy, the U.S. is going to have a natural growth rate of between 2% to 3%. To push growth above that pace is certain to come with consequences.
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