Stocks & Bonds Diverge
After rising in lockstep for most of this year-to-date, stocks and bonds moved in dramatically different directions after a week chocked full of market moving developments. At just the time when a lack of stock volatility became newsworthy, equities suffered their worst week of losses this year, declining by over 3 percent on the S&P 500. Losses in blue chip stocks defined a clear break with bonds, whose rally gained steam amid the Fed’s first rate cut since the end of 2008. In a significant risk-off rally, bond yields on benchmark 10-year U.S. Treasuries fell to 1.85 percent, the lowest level since U.S. presidential elections in the fall of 2016.
Not So Fast
Against the backdrop of second quarter corporate earnings season now beginning to wind down, the Fed dropped short-term interest rates by a quarter of a percent Wednesday, a move widely expected by the capital markets. What surprised investors was Fed chair Powell’s comment that the rate cut was a “mid-cycle adjustment,” with the implication being that additional rate cuts this year are not a sure thing. As it has in the past, the Fed is signaling its dependence on incoming economic data to determine the path of future short-term interest rates.
No sooner had Fed funds futures markets dropped the odds of another rate cut at the next Fed meeting than the U.S. announced new tariffs on another $300 billion of Chinese imports. Perhaps not coincidentally, the new 10 percent tariff on what would largely impact consumer products like apparel and cell phones is threatened to take effect in September, which also happens to be when the Fed next meets to decide monetary policy. The Fed’s rate cut this week acknowledges a slowdown in economic growth globally, as well as the persistent shortfall of U.S. inflation relative to its 2 percent mandate. As portrayed in the chart below, we believe a key reason for slower GDP growth at this point is the reduction in business leaders’ confidence, which is now weighing on corporate investment.
Regardless of whether the most recent threat of tariffs takes place, the uncertainty of trade policy itself is what gives business leaders pause and is a key factor the Fed will have to consider when it next meets to decide interest rate policy. For now, the emerging weakness in capital spending is weighing on activity in the manufacturing sector, which weakened in July to a three-year low on the ISM Manufacturing Index.
What continues to backstop the expansion domestically is a healthy U.S. consumer who is employed at record levels and now increasingly the beneficiary of lower long-term interest rates. While U.S. housing has experienced a slower pace of housing starts and turnover of late, this important component of the U.S. economy stands to benefit from 30-year mortgage rates now well below 4 percent. Time will tell the degree of support offered by lower rates, but in an economy where U.S. consumers remain the key driver of economic growth, we believe activity levels in the housing market may emerge as a positive offset to reduced levels of corporate investment.