180-Degree Shift

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by Peter Jones, CFA
Vice President of Research

After a huge run to start the year, equity markets declined throughout May as trade tensions re-escalated and fears of slowing economic growth came back into focus. This week, equity markets moved sharply higher with the S&P 500 closing within 2.5 percent of its all-time high.

Did trade tensions ease? No. In fact, the U.S. is set to slap 5 percent tariffs on Mexico this Monday and an additional 5 percent every month after that.

Did economic data improve? No. Global manufacturing surveys continued to soften and the U.S. job report revealed that the economy added 75,000 jobs in the month of May compared to expectations for 182,000.

Despite these recent developments, equity markets rallied as a result of increasing optimism that the Federal Reserve will cut interest rates imminently and will do so multiple times before the end of the year. This optimism is fueled by commentary from various Fed Governors and Chairman Powell, along with the aforementioned job report. About a year ago, consensus expectations were that the Fed would hike interest rates two times in 2019. The 180-degree shift is nearly complete.

Futures markets, which have proven to be the most reliable predictor of monetary policy, are pricing in a 97-percent probability that the Fed will cut rates by the end of September. Even more astonishing, there is a 68-percent probability that the Fed will cut rates either two or three times by the end of the year. This is notable due to the appearance of a disconnect between economic data and market expectations for rate cuts.

GDP is growing around 2 percent, consumer confidence just hit a new high for this expansion, unemployment of 3.6 percent remains at multi-decade lows, and corporate earnings continue to move higher. While the global economy is certainly slowing, it is hardly a desperate situation. Instead, bond markets are begging the Fed for an “insurance” cut. Markets determine mid- and long-term interest rates, and central banks determine short-term rates. When short-term rates are higher than long-term rates, a yield curve inversion occurs, as seen in the chart below.

Source: FactSet

This is the market’s way of telling central banks that rates need to be cut. If The Fed doesn’t, it will provide a shock to bond markets that will lead to a tightening of financial conditions and thus cause equity market declines. This transmission mechanism would serve to slow the real economy and force the Fed to cut interest rates. The Futures market has become a self-fulfilling prophecy.

In short, the bond market is forcing the Fed’s hand. Typically, easing when the economy is relatively strong brings about the risk of a sharp increase in inflation. However, with inflation remaining stubbornly low, as indicated in the chart below, the Fed has a green light to proceed with rate cuts. While it is not our opinion that the global economy needs additional stimulus, inflation should allow the Fed to bend the knee to bond market participants without the risk of runaway inflation.

Source: Bloomberg

Week in Review and Our Takeaways

  • Equity markets rallied sharply on the week

  • Bond markets are begging the Fed to cut interest rates

  • Stubbornly low inflation allows the Fed to provide stimulus without risking runaway inflation