Published on Jul. 15, 2019
Pivots and Puts
Market lore has it that former Federal Reserve Chairpersons Greenspan, Bernanke, and Yellen all provided the markets with what was effectively a put option. Hence the term, the “Greenspan Put”. If the economic signals started to get tough, the Fed would provide accommodative policy. This course of action would then presumably lead to a rally in bonds and stocks. Bonds would increase in price with the lower interest rates and the equity markets would rise on the prospect of continued economic growth. Former chair Yellen even suggested in a recent speech that the Fed should buy stocks and corporate bonds during recessions to help support the economy.
We believe that this policy has been easy for the Fed to carry out because of the lack of inflation. There’s vigilance for inflation, it is feared, but it hasn’t shown up. The Fed has not yet been caught in the dreaded place where they are behind in a fight against inflation. Since monetary policy acts with a lag, a Fed caught late in snuffing inflation has historically been a disaster.
Inflation has been kept at bay by the confluence of technology, global competition, and demographics, in our opinion. Technology has reduced costs, spurred competition, made pricing more competitive, and generally empowered consumers rather than producers. All this happens on a global scale. Demographics have been impactful too. As the developed world has grown older, there is less demand for goods and more demand for fixed income assets. Apparently, any reasonable instrument with yield is in demand. Pricing power in goods and services has seemingly been constrained by these forces.
Federal Reserve Chair Powell in Congressional testimony this week indicated that the door is open for the Fed to lower rates later this month. Powell served on the Fed uneventfully for six years before he was named Chair in early 2018. Perhaps only after he became Chair did he fully understand the import of his every utterance. Charitably, his October 2018 off-the-cuff comments about rates being low and “far” from normal may have added to the equity and credit spread woes of Q4 2018. By January 2019, Powell was inclined to read prepared comments and he gave us the term “patient”. Specifically, the Fed would be patient before raising rates. For Powell, being patient was a pivot and – in the end – it is a put too. This is the same accommodative stance that we have had from his predecessors. With inflation MIA, raising rates is not an imperative.
In our opinion, equities have responded positively and bond yields have returned to lower levels. The bond market now seems to have priced in several reductions in the Fed funds rate; the implied consensus of the CME FedWatch Tool is that by year-end, there will be two reductions of 25 basis points each. But bonds are also indicating an all clear signal on inflation. Because there are several narratives at play here, the story gets interesting.
Loud noises abound predicting an imminent recession. These voices could be rewarded with an expected Q2 manufacturing output data report likely to show a second straight quarter of declines, among a backdrop of weaker conditions overseas. The Fed is anxious about trade tensions and the waning strength of the global economy. But will there be a recession? US retail sales and housing activity are more robust, employment continues to be strong, and corporate profitability is not plummeting. In Powell’s mind though, even with the strong June jobs report, the economic outlook is not improving. Perhaps given the heightened trade-related uncertainties from the on again/off again status of increased tariffs on Chinese goods, a so-called ‘insurance’ cut is in order.