Sunday, June 09, 2019

Seems All About The Fed At The Moment

Since the Federal Reserve began raising the Fed Funds rate in December 2015, there have been nine rate increases. Now that the Fed is in a pause mode, strategists and investors have turned their focus on rate cuts. It seems as though strategists believe the equity market and economy can not move ahead unless the Fed cuts interest rates. By now many have heard that every recession since World War II has been preceded by an inverted yield curve, i.e. short term interest rates are higher than long term interest rate. And therein lies the issue with the focus on the Fed's interest rate decisions.

Our firm pays attention to various economic variables and an an important one is the yield curve. Yes, the 3-month/10-year Treasury curve has inverted; however, we place a great deal of weight in the 2-year Treasury/10-year Treasury yield curve as well. The 2y/10y Treasury yield curve has not inverted in this economic cycle as noted by the line in the below chart as it has remained above zero since the end of the financial crisis.

The small spread in the above chart is representative of a flattish yield curve for the 2y/10y spread. The red line in the below chart represents the current shape of the yield curve. Clearly the very short end of the curve has inverted relative to the 10-year Treasury bond yield.

Generally, the Fed begins to increase short term interest rates in an effort to get rates back to a more normal level as the economy nears full employment and to keep inflation at a targeted level. Prior to Fed Funds rate increases, the rate has been below a normal level as rate reductions were likely initiated in an effort to stimulate economic growth coming out of a recession. So now, if the Fed begins to reduce interest rates near term, is the Fed seeing signs of an economy that is slowing and slowing to the point of a recession? A similar rate pattern played out in the mid 1990's as seen in the below chart. At that time after beginning a rate increase cycle, the Fed reduced rates a few times and the economy continued on its expansionary track for five more years. This type of pattern could repeat itself later this year.

And lastly, recently I have seen charts noting equity market weakness during Fed Funds rate decreases. During the mid-1990 period though, the equity market continued on its upward growth trajectory as seen below.

Finally, putting the equity market and fed funds rate changes in perspective, Sam Stovall, chief investment strategist at CFRA Research, published an article in the AAII magazine in 2009, Don't Fight The Fed; Interest Rates and Their Impact on the Stock Market. The article evaluates S&P 500 changes 6 months and 12 months after rate increases and decreases from 1946-2008. In both periods, equity market returns were higher. The highest returning periods were the 6 and 12 months following rate cuts as seen below.

The article does point out the equity market is less predictable during the rate cutting period in the 6 month time frame:
  • "...the stock market advanced fewer than two of every three times in the six months following the first rate cut. That 62% conviction level is not very encouraging, in my opinion. I think it is safe to say, therefore, that an investor could have been justified in not responding to the Fed’s actions during the first six months of an interest-rate easing cycle."
  • "However, the market rose 85% of the time in the 12 months after the first rate cut. I believe this statistic is the most compelling for why you don’t want to wait too long in responding to the Fed’s actions. Eventually the Fed will get it right."
Current economic data is mixed and some of the weaker data is worth accounting for in ones analysis going forward. However, news headline sentiment seems to be projecting a more dire economic environment at this point in time. One concern is, collectively, we can talk ourselves into an economic slowdown in spite of strong economic underpinnings. The current environment though seems more like a 2015/2016 slowdown and not one where a full blown recession is on the horizon, but the environment is a more fluid and challenging one for sure.

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