Market going crazy? Blame wacky ol’ Fed, Trump concludes
The one thing many investors may agree on is damper of rate hikes, Joe Chidley says.
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 ratehiking 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-percent 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 seven-year intraday high of 3.26 per cent, up more than 15 basis points from Oct. 1.
Then, because everything is connected, the bond selloff 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 risk-free 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.
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.