Veruca Salt and the Bond Market

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by Brad Houle, CFA
Executive Vice President

Veruca Salt was a character in the novel and film Charlie and the Chocolate Factory. Her character was the greediest, most spoiled child of all the children that received a “Golden Ticket” and had the opportunity to tour the Wonka Chocolate Factory. Veruca's parents catered to her every whim – she even famously demanded she have an Oompa-Loompa to keep as a pet. Her father agreed that she would have it by the end of the day despite the obvious inherent ethical challenges of a request to keep a human being as a pet. The bond market can be seen as having some Veruca Salt characteristics recently, and rather than demanding an Oompa-Loompa the bond market is telling, not asking, the Federal Reserve to cut interest rates. These demands by the bond market come in the shape of the yield curve or term structure of interest rates.

Looking back at 2018 the bond market was anticipating around three rate increases in 2019 and 2020. While the economy is still growing, it is doing so at a decelerated rate and around the time of the end of 2018 the bond market started to price in rate decreases based on the slowing economy.  Part of the market turbulence that was encountered in December was a fear by market participants that the Federal Reserve was on a path to continue increasing interest rates without any thought to the damage that it might be doing to the economy. Early in 2019, Fed Chairman Powell acknowledged the softness in some economic data and assured the market that the Fed was not on a predetermined path of increasing interest rates. This change in sentiment has been labeled the "Powell Pivot" and was greeted with delight which in part drove the strong equity market performance this year.

This week there was a meeting of the Federal Reserve and the subsequent communication in the press release and press conference was higher stakes than usual. If the Federal Reserve's intentions were not communicated carefully, a violent reaction could have been experienced in the stock and bond markets. Fed Chairman Powell was masterful in his delivery of precisely what the financial markets wanted to hear. The White House shared a similar opinion to the bond market in terms of the direction of interest rates; however, the Fed is apolitical, and we believe the Federal Reserve is acting accordingly.

While the Federal Reserve appears to be listening to the demands of the bond market, there is data to support their position of being open to rate cuts in future meetings. The Federal Reserve has a dual mandate, full employment and price stability. With unemployment around 3.6 percent there is no question that the country is at full employment. In terms of price stability, there is less inflation than the Fed would like to have. Too much or too little inflation is a bad thing. Most people are familiar with the hazards of too much inflation as this happens in many emerging economies and it is readily observable what damage has been done. Japan suffered deflation for many years and the risk of continually dropping prices can become a negative feedback loop. One risk is that consumers know prices are moving lower and therefore delay purchases, further causing prices to drop.

There are many ways to measure inflation. The Federal Reserve likes to use a measure called the PCE which is similar to the more familiar Consumer Price Index. The Fed has a target of plus or minus 2 percent for inflation. Recently, this lack of inflation and slowing global growth is what has caused the Fed to be open to rate cuts. These anticipated rate cuts are considered "insurance cuts" against a possible recession because the economy is still growing, but slowly.

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This week the news from the Fed helped to propel the S&P 500 to record levels. For the year to date, the S&P 500 is up 18.87 percent. Longer bond yields dropped on the news this week with the 10-year U.S. Treasury finishing at 2.06 percent.

Week in Review and Our Takeaways:

  • The bond market is going to get what it has demanded, the base case is for an "insurance" interest rate cut in the July Fed meeting

  • The lack of inflation and slower global growth are driving the expectation of rate cuts