The interest rate changes of the last few years tell an interesting story and provide lessons for later in 2019.
One reason stocks and bonds appreciated following the financial crisis and especially from 2016-2018 is that the Fed tightened monetary policy much less than investors expected. After years of the Fed doing less than expected, investors came to believe that would continue indefinitely. Many even believed the Fed was putting a floor on stock prices.
In 2018, the Fed surprised investors by tightening monetary policy much more than was expected at the beginning of the year.
The tightening had significant effects. In addition to withdrawing liquidity from the economy and markets, the Fed changed investor expectations about interest rates.
Investors re-price assets when their outlook for interest rates changes. Higher interest rates cause investors to lower asset prices.
Futures prices on the Fed Funds rate reveal investor expectations and show how the expectations change.
In mid-2018, the futures markets indicated there would be at least one interest rate increase by the Fed in 2019, and by the fall of 2018 there was greater than a 30% probability of two increases in 2019. Those increases would be in addition to the ones already expected for 2018.
It is no surprise that stock and bond prices fell in the last quarter of 2018 given the expectation of more interest rate increases.
The Fed announced a suspension of its tightening policy near the end of 2018. That suspension had two effects.
One effect was that it stopped taking liquidity out of the economy and markets. The other effect was to change investors’ expectations.
By early 2019, the futures markets indicated there was a 90% probability of no interest rate changes by the Fed in 2019. By mid-February, investors began to expect interest rate cuts from the Fed in 2019. Now, there’s only a 31% probability of no change in interest rates. There’s almost a 70% probability of at least one interest rate reduction in 2019.
Because of the change in expectations, stock indexes are almost back to their 2018 highs. Market interest rates tumbled and bond prices rose. Commodities also rallied.
The key lessons are that investor expectations matter a lot, and changing expectations can move market prices quickly.
Once the Fed took the expected 2019 rate increases off the table, investor expectations changed and assets were re-priced higher. The economy and markets received the benefit of one or two interest rate cuts without the Fed actually having to cut rates.
But now we’re in a more difficult period. As I said, futures markets indicate investors now expect the Fed to cut rates at least once in 2019. I don’t think that’s going to happen unless the economy slows far more than the Fed expects.
That could be a problem for investments later in 2019. When the Fed leaders voice contentment with the modest rate at which economic growth settles and won’t cut rates, we’ll be back to a period when the Fed has a tighter policy than investors expect. Investors might re-price stocks and other assets to lower levels.
After months of disappointing results, retail sales took off in March. Sales increased 1.6%, the largest monthly increase since September 2017. Much of the increase was in spending for autos and gasoline. But after excluding autos and gas, retail sales still increased 0.9%. Over 12 months, retail sales increased 3.6%.
Manufacturing activity appears to be taking a pause after recovering from its lows of 2018.
The Empire State Manufacturing Survey increased to 10.1 from 3.7. But details of the report were mixed. Importantly, the manufacturers’ six-month outlook was at its lowest level in more than three years.
The Philadelphia Fed Business Outlook Survey declined to 8.5 from 13.7. The good news in the survey is that new orders increased after declining in last month’s report. Also, unlike the Empire State survey, respondents were optimistic about the next six months.
Industrial Production declined 0.1% following a 0.1% increase last month. The manufacturing sector of the report was unchanged following a 0.3% decrease last month.
The good news in Industrial Production is that business equipment production increased 0.4% after a 0.8% decline last month. Over 12 months, business equipment production increased 3.8%. This indicates businesses are slowly expanding to meet demand.
The service sector of the economy slowed a little in the first half of April, according to the PMI Composite Flash Index. The composite declined to 52.8 from 54.3. The manufacturing sector declined a little to 52.4 from 52.5. But the service sector declined to 52.9 from 54.8.
The Leading Economic Indicators Index from The Conference Board grew by 0.4% compared to a 0.1% increase last month.
Home builders still are positive. The Housing Market Index from NAHB increased to 63 from 62. Lower mortgage rates are helping the index recover slowly from the steep drop at the end of 2018.
Consumer Sentiment, as measured by the University of Michigan, declined to 96.9 from 98.4. The assessment of current conditions increased, but a decline in expectations more than offset that.
New unemployment claims declined yet again. Claims fell by 5,000 for a total of 192,000 for the week. That’s the lowest level since September 1969.
The S&P 500 rose 0.40% for the week ended with Wednesday’s close. The Dow Jones Industrial Average added 1.18%. The Russell 2000 declined 0.77%. The All-Country World Index (excluding U.S. stocks) gained 0.76%, while emerging market equities rose 0.16%.
Long-term treasuries declined 1.63% for the week. Investment-grade bonds fell 0.61%. Treasury Inflation-Protected Securities (TIPS) gave up 0.61%. High-yield bonds lost 0.07%.
On the currency front, the dollar increased 0.19%.
Energy-based commodities declined 0.90%. Broader-based commodities fell 1.85%. Gold lost 2.48%.
Bob’s News & Updates
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