Federal Reserve officials must be dizzy from the numerous policy changes that they’ve made the last few years. Investors and markets are being taken along on the ride.
Only last September, Fed officials were making it clear that they wanted to raise interest rates to near historic averages within the next few years. They believed the economy was robust, higher inflation wasn’t a threat and that the economy could handle higher interest rates.
The Fed already had raised rates several times in 2018. The Fed indicated more rate increases were likely in 2018 and that rates would be raised further in 2019.
Those Fed actions and commentary sent stock and commodity prices into a dive. I don’t have to remind you how much those prices declined in the last quarter of 2018.
More importantly, the economic data began to deteriorate. The economy clearly was slowing in the United States and elsewhere.
By late December, Fed officials began stating publicly that interest rate increases in 2019 likely were off the table. The Fed made that official with votes and comments after its meetings in early 2019. Changes in monetary policy would be on hold. The Fed would wait for more economic data before deciding its next move.
The pause looks like it might not last long.
This week, Fed officials began hinting that interest rate reductions could be in the future.
The big market mover was Fed Chairman Jerome Powell’s comments on Tuesday. He didn’t say much, but Fed watchers always read between the lines. Powell said the Fed would “act as appropriate” to extend the economic expansion.
Following the remarks, the major stock market indexes had their best one-day gains in five months.
Both the Fed and the markets are particularly concerned about the latest trade conflicts between the United States and China and the United States and Mexico.
The Fed has several problems that it has to balance.
Because of the expansive monetary policy following the financial crisis, the Fed has few tools left to reverse the next recession. Interest rates already are near zero, even after the increases of the last few years. The Fed’s balance sheet is very large, though it’s been reduced over the last year.
Also, interest rate cuts and balance sheet expansion had less effect on the economy each time the Fed used them during the post-crisis period. The Fed needs to keep these tools in reserve until they’re really needed.
On the other hand, because its tools are limited, the Fed can’t risk letting a recession begin. It needs to act early to keep the economy from decelerating. Otherwise, the Fed might not be able to reverse a downturn.
A third problem that has to be balanced is that investors are expecting multiple rate cuts in 2019.
Futures markets indicate there’s a 59% probability of a rate cut at the Fed’s July meeting, and a 75% probability of two cuts in 2019. There’s also a 53% chance of three rate cuts by the end of the year.
That’s a big change from the multiple rate increases that were priced into the markets in the fall of 2018.
It also means that the Fed has to worry what how markets will react if the Fed doesn’t meet expectations. The interest rate cuts already are factored into market prices. If the Fed doesn’t cut rates, investors might decide to re-price assets, reducing the prices of stocks and bonds.
The potential good news is that the futures markets might be misleading. The rapid shifts in Fed policy and interest rate expectations over the last year or so caused a number of traders to be caught on the wrong side of the market’s movement. The extreme changes in futures prices could be the result of traders rapidly overhauling their portfolios, especially those trying to cover short sale positions. If that’s the case, stock and bond prices might not have two or three interest rate cuts factored into their prices.
I discuss these issues in more detail in my June 2019 Retirement Watch Spotlight Series online seminar, which will be available next Friday. It’s my semiannual economic and market review. Learn more about the Spotlight Series here.
As the Fed ponders what to do next, expect market volatility to continue. Be sure that your portfolio is diversified and that each investment has a margin of safety.
The PMI Manufacturing Index says that particular sector of the economy is barely growing. The index declined to 50.5 from 52.6. A level above 50 indicates growth. New orders were below 50 and at their lowest level in 10 years. Export orders also were below 50.
The ISM Manufacturing Index was a little better, declining to 52.1 from 52.8. Most components of the index showed modest growth. That still is the weakest level for this index since October 2016. This index has a broader base than the PMI and generally is considered a better measure of the sector.
Consistent with those surveys, Factory Orders declined 0.8% and last month’s increase was revised lower to 1.3% from 1.9%. The durable orders component of the report declined 2.1%. Core capital goods, which are considered a good measure of business investment, declined 1.0%.
The reports on the service sector of the economy are more mixed.
The PMI Services Index declined to 50.9 from 53.0. That is the lowest level for this index since February 2016. Business confidence also reached a three-year low. Even so, the employment component of this report was strongly positive.
But the ISM Non-Manufacturing Index increased to 56.9 from 55.5. Components of the index that were particularly strong were employment, new orders and business activity.
Business investment over the last couple of years appears to be paying off. Productivity in the first quarter increased 3.4%. Output rose 3.9% and hours worked rose only 0.5%. Compensation rose only 1.8%. So, unit labor costs decreased 1.6%.
The ADP Employment Report of private sector job growth was unexpectedly weak. ADP said only 27,000 new jobs were created in May, compared to 271,000 in April and the expectation that there would be around 175,000 new jobs. This raises a lot of uncertainty about Friday’s Employment Situation reports.
Consumer Sentiment, as measured by the University of Michigan, is still strong but declined to 100.0 from 102.4. Expectations improved, but the assessment of current conditions declined.
Household income rose 0.5% in April, according to the Personal Income and Outlays report. Wages and salaries rose 0.3% for the month, with interest, dividends and other payments making up the rest of the increase in income. Consumer spending increased only 0.3% for the month, but March’s increase was revised upward to 1.1% from 0.9%.
Inflation, as measured by the PCE Price Index, rose 0.3% in April and 1.5% over 12 months. Excluding food and energy, the price index increased 0.2% for the month and 1.6% over 12 months.
The Chicago Purchasing Managers’ Index ended two months of declines by rising to 54.2 from 52.6. New orders had their first increase in three months, but other components of the index were mixed.
New unemployment claims were unchanged from last week at 218,000. The four-week average declined to 215,000.
The S&P 500 rose 1.69% for the week that ended with Wednesday’s close. The Dow Jones Industrial Average increased 1.77%. The Russell 2000 added 1.25%. The All-Country World Index (excluding U.S. stocks) gained 1.33%. Emerging market equities grew 1.21%.
Long-term treasuries rose 1.06% for the week. Investment-grade bonds increased 1.09%. Treasury Inflation-Protected Securities (TIPS) added 1.09%. High-yield bonds gained 0.88%.
The dollar declined 0.68%.
Energy-based commodities declined 7.12%. Broader-based commodities fell 4.20%. Gold increased 3.92%.
Bob’s News & Updates
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