Joe Chi­d­ley: Mar­ket go­ing crazy? Blame that wacky ol’ Fed, Trump says

The Expositor (Brantford) - - BUSINESS - JOE CHI­D­LEY FI­NAN­CIAL POST

The U.S. Fed­eral Re­serve is plum loco. Like, down­right crazy.

At least that’s the di­ag­no­sis U.S. Pres­i­dent Don­ald Trump of­fered this week, by way of ex­plain­ing a stock mar­ket plunge that shaved more than three per cent from the Dow Jones in­dus­trial av­er­age on Wed­nes­day.

So no, the rout wasn’t caused by grow­ing worry over Trump’s trade wars, which the In­ter­na­tional Mon­e­tary Fund cited in cut­ting its out­look for global growth on Tues­day. Nope, it’s the crazy ol’ Fed un­der that chair Jerome Pow­ell.

“The Fed is go­ing wild,” Trump told Fox News on Wed­nes­day night. “They’re raising rates and it’s ridicu­lous.”

Well, take that for what it’s worth. Still, while many in­vestors might not con­cur with Dr. Trump’s di­ag­no­sis, they might tend to agree with the un­der­ly­ing sen­ti­ment: U.S. in­ter­est rate hikes are or are go­ing to rain on the stock mar­ket’s pa­rade.

Now, ex­plain­ing mar­ket ac­tions through psy­chol­ogy is prob­a­bly as much a mug’s game as psy­cho­an­a­lyz­ing a Fed chair from afar. But let’s look at the ac­cepted script for what’s been go­ing on in the mar­kets. Some an­a­lysts as­cribed the Wed­nes­day down­turn, which mod­er­ated but con­tin­ued on Thurs­day, at least in part to the IMF down­grade to global growth. Yet other fac­tors, which might have more di­rect im­pli­ca­tions for U.S. mon­e­tary pol­icy, were also taken to play a part.

For in­stance, the Septem­ber U.S. jobs re­port, which came out on Oct. 5, found the un­em­ploy­ment rate had dropped to 3.7 per cent, a nearly 50-year low; wage growth also strength­ened. Now, in tra­di­tional eco­nomic think­ing, low un­em­ploy­ment leads to ris­ing wages, which leads to in­fla­tion, which leads to higher pol­icy rates. So the jobs data might have sug­gested to the mar­ket that the Fed would ac­cel­er­ate its rate-hik­ing cy­cle, be­yond one more in De­cem­ber and three more next year, as it im­plied in its pol­icy meet­ing on Sept. 26.

Other data have also been stok­ing in­fla­tion ex­pec­ta­tions — higher en­ergy prices, the Septem­ber Pro­duc­ers Price In­dex (up 0.2 per cent), the 4.2-per-cent Q2 GDP growth re­ported at the end of Septem­ber. All that has had an im­pact on bond mar­kets, in the form of a sell-off and cor­re­spond­ingly ris­ing yields. On Tues­day, 10-year Trea­sury yields hit a sev­enyear in­tra­day high of 3.26 per cent, up more than 15 ba­sis points from Oct. 1.

Then, be­cause ev­ery­thing is con­nected, the bond sell-off might have fed the rout on Wed­nes­day. For one thing, it was yet an­other sign of more Fed hikes to come. And con­sid­er­ing that the div­i­dend yield of the S&P 500 is be­low two per cent, stocks might start to look less at­trac­tive to in­vestors; a risk­free 3.2-ish re­turn could be too juicy to re­sist. And higher rates down the road would make stocks look even more like bonds’ ugly brother.

Now, if you dis­count the trade ten­sion/global slow­down the­ory for this week’s stock sell-off — and I wouldn’t do that, but let’s say you did — then you’ve got to think that the mar­ket is fear­ing that the Fed will re­spond to in­fla­tion­ary sig­nals with more hikes than in­vestors pre­vi­ously ex­pected, maybe enough to hurt cor­po­rate profits, or dim the U.S. econ­omy into re­ces­sion, or at least shift cap­i­tal flows into bond mar­kets at the ex­pense of eq­ui­ties.

This all makes sense, but it might be based on some ques­tion­able as­sump­tions. One is that U.S. bond yields are poised to soar. I’m not so sure. Ob­vi­ously, higher yields make Trea­suries more at­trac­tive, but if higher yields in­crease de­mand, that will serve to cap yields. And the fact is, Trea­suries were al­ready pretty at­trac­tive, at least com­pared to other sovereigns. In Ja­pan, 10-year bonds are not even pay­ing 15 ba­sis points. Mean­while, yields in Europe re­main sup­pressed: the Euro­pean Cen­tral Bank is plan­ning to stop its bond-buy­ing pro­gram by the end of this year, but it’s not go­ing to start un­wind­ing its $3.8-tril­lion bond hold­ings any­time soon. So even in Italy, which is in the midst of a bud­get cri­sis, the 10-year bond yield is just above 3.5 per cent — not much of a risk pre­mium over Trea­suries there.

An­other prob­lem with height­ened in­fla­tion ex­pec­ta­tions is that real in­fla­tion hasn’t shown much life. On Thurs­day, the U.S. core con­sumer price in­dex for Septem­ber came in at 2.2 per cent. That was lower than econ­o­mists’ es­ti­mates, and pretty much in line with the Fed’s two per cent target. In short, Septem­ber at least didn’t pro­vide any ev­i­dence that in­fla­tion is get­ting out of hand.

Fi­nally, in­vestors might want to look at how the Fed is think­ing about the as­sumed re­la­tion­ship be­tween low un­em­ploy­ment, ris­ing wages, in­fla­tion and mon­e­tary pol­icy. In a speech in Bos­ton on Oct. 2, Jerome Pow­ell pointed out that at least since 1995, there has been no con­sis­tent in­verse cor­re­la­tion be­tween low un­em­ploy­ment and ris­ing in­fla­tion. Again point­ing to his­tory, he also noted “higher wage growth need not be in­fla­tion­ary. The late 1990s episode of low un­em­ploy­ment saw wages rise faster than in­fla­tion plus pro­duc­tiv­ity growth with­out an ap­pre­cia­ble rise in in­fla­tion.” He also men­tioned the Fed is mon­i­tor­ing other risks — “the strength of economies abroad, the ef­fects of on­go­ing trade dis­putes, and fi­nan­cial sta­bil­ity is­sues” — all of which, if they prove real, would sug­gest less tight­en­ing rather than more as a mon­e­tary pol­icy re­sponse.

In short, it’s hard to see in Pow­ell’s speech many signs the Fed is poised to de­vi­ate from its steady course to­ward nor­mal­iza­tion so as to crush in­fla­tion at any sign of labour mar­ket tight­en­ing or ris­ing wages. Which makes it not easy to see the cur­rent sell-off last­ing very long — if in­deed Fed fear is be­hind it.

At least it’s not easy if you lis­ten to Jerome Pow­ell. But hey, what does he know? He’s nuts.

Jerome Pow­ell, chair­man of the U.S. Fed­eral Re­serve

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