- Politics don’t seem to matter much to markets until they matter
- The S&P 500 is down about 7% from its late-April high
- The yield curve inversion seems to be giving investors jitters of recession
As usual, there is a lot to digest and this is only a partial list, but it incorporates the essentials. The larger anxieties are being generated in the geopolitical realm, and yet cooler heads recognize that all sides in trade disputes need deals. It is at least true that everybody could be better off.
But this doesn’t guarantee that the necessary accommodations and arrangements will happen. At a minimum, we believe that continued tensions could lead to lower economic growth, perhaps a recession. The market’s view on this, it seems, is that the Federal Reserve stands ready to ease.
As of this writing, the yield on the active US Treasury notes, out to the ten-year maturity, all trade lower than the Federal funds rate. This is understood to reflect the bond market having already “priced in” the next interest rate moves by the Fed’s rate-setting body to be a reduction in the Fed funds rate. Explicitly, the CME’s Fed Watch Tool records over a 50% chance of a lower Fed funds rate being priced in at the FOMC’s July 31st meeting.1
Remember that the Fed has two important objective functions: full employment and stable price levels, and it attempts to implement policy targeting these two objectives with essentially one tool, adjusting the level of short-term interest rates. The geopolitical threat, through trade tensions, is a threat to employment. Specifically, the forward concern is whether a rise in the cost of goods (the result of tariffs and restraint of trade) would cause reduced consumer spending, job losses, and a drop-off in economic growth. This is the case for the Fed to take proactive steps and lower rates.
There is, however, an additional reason for the Fed to lower rates. With regard to the Fed’s 2% inflation target, inflation has stubbornly refused to cooperate and has remained consistently below that target. Recent comments by Fed Chair Powell, Vice Chair Clarida, Former Fed Chair Yellen, Boston Fed President Rosengren, Chicago Fed President Evans, and New York Fed President Williams have all addressed the Fed’s efforts - and lack of success - in pushing inflation towards that 2% target. The number is important because the Fed sees it as consistent with healthy economic growth. If markets, households, and businesses expect inflation to remain below 2%, the Fed’s concern is that lower growth expectations become ingrained.
Fed funds currently are targeted at 2.25-2.50% and inflation readings are closer to 1.5%. Given this, the expectation of a rate cut seems justified by the shape of the yield curve and the CME’s Fed Watch Tool. What’s missing from this analysis is that the GDP trackers, which are compilers of economic data providing running totals in real-time, are not indicating that the economy is moving into recession at all for the second quarter. It might be useful therefore to view the yield curve’s protest as one of too low inflation, rather that of negative economic growth.
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