August 2019
Since the interest rate cut at the end of last month, economic data has continued to suggest that the economy is growing moderately despite some trepidation in the manufacturing sector over trade tensions. Despite that fear, services and consumption continue to drive the economy. Moreover, with the workforce at full employment and wages rising faster than inflation, consumers are likely to continue to support the economy. Further emboldening the consumer is the ongoing strength in the stock market. The cycle of sudden stock price weakness followed by fresh buying and new highs has yet to have been broken. Especially instrumental has been corporate America’s appetite for stock buybacks. It’s been well documented over recent years that with low interest rates corporations are able to issue debt and use those proceeds to buy back shares. An example of the strategy unfolded last week when Coca-Cola issued 5 and 10-year corporate bonds. On an after tax basis, the deal allowed Coca-Cola to borrow at a mere 1.56%!
Despite the stable economy and frothy stock market, Fed Chairman Powell said in his speech at the Swiss National Bank on September 6 that he and the FOMC will do whatever is necessary to perpetuate economic growth. Market participants have interpreted that comment to mean that he will announce another 25 basis points rate cut at the conclusion of the September 18th FOMC meeting. While the various Fed speakers have sounded a similar message, the desire to cut rates again this month is not shared by all of them. Several have expressed a desire to leave the rate unchanged for the time being, while St. Louis President Bullard has said he would like to see the rate cut by 50 basis points.
As justification for their preference to cut interest rates, several Fed officials have cited the inverted yield curve as a predictor of an oncoming recession, which is absurd given that the Fed’s buying of Treasury bonds in the open market is part of the reason for the inversion. On September 6th, in the midst of a massive Treasury short-squeeze, the Fed bought $2.2 Billion of 20 to 30-year Treasury bonds in the open market. It doesn’t take a rocket scientist to understand that buying bonds in the midst of a rally is going to further push prices higher, driving down interest rates, and thereby further inverting the yield curve. Of course that may be exactly what the Fed wants. By driving the entire term structure of interest rates lower, they encourage the type of balance sheet arbitrage so many corporations have exploited. There’s certainly no doubt that nearly free money will juice economic activity.
The problem with that mentality is that when there is a weakening in consumer confidence or should a financial panic develop, the Fed will have limited “dry powder” in terms of dropping interest rates to calm fears. There has been some discussion that in such a scenario the Fed could follow the European Central Bank strategy of negative interest rates and open market purchases of non-government securities such as corporate bonds or publicly traded equities. While a negative interest rate is a possibility, we think the Fed would face a very high hurdle from Congress and the banking sector if they were to choose that path. As for purchasing non-Treasury issued securities in the open market, we think the hurdle is even higher. If they were to do that they would be directly benefiting the shareholders of the securities they were buying, and thereby interrupting the competitive forces of the marketplace. Moreover, they would find themselves in the business of picking winners and losers and would face accusations of anticompetitive behavior. Very quickly one can easily deduce the myriad problems, accusations, and lawsuits such activity would bring. Nevertheless, such options have been discussed as potential emergency measures.
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