Fed Walks a Tightrope in Efforts to Normalize Without Pain
As the stock market has continued rising and falling like a stormy ocean over the last several months, the bond market settled into a period of relative calm. After spiking to 3.11 percent in mid-May, the yield on the 10-Year Treasury dropped below 3 percent by the end of the month and hovered just below 2.90 percent from late June all the way through late July.
It finally crept a bit higher again at the end of July in response to a massive move in Japanās interest rates stemming from concerns over the Bank of Japanās efforts to continue tightening monetary policy after years of quantitative easing. This was just the latest example of something Iāve discussed often in this space. The financial markets have a dangerous addiction to artificial economic stimulus, which means we could face a wildly unpredictable fallout as central banksāincluding our own Federal Reserveāattempt to ānormalizeā their balance sheets again.
Could that fallout include a whole new, possibly even worse financial crisis and an economic downturn even āgreaterā than the Great Recession? No one knows, of course, but itās no secret that the Fedās job hasnāt gotten any easier since Donald Trumpās election despite a lot of political hype around how great the stock market and U.S. economy have been doing.
As an article in MarketWatch put it recently, the Fed right now is āwalking a tightrope as it aims to normalize interest rate policy without suffocating economic growth or fostering bubbles or another recession.ā1 Wall Street is watching this tightrope walk very closely.
Temporary Surge
Economic growth doesnāt appear to be in danger of suffocating just yet. As you probably know, GDP growth for the second quarter hit 4.1 percentāthe growth rate touted by Trump on the campaign trail. That was a jump from just over 2 percent for the first quarter, and Trump immediately proclaimed the increase was a direct result of his corporate tax cuts and called the growth rate āvery sustainable.ā
Economists, however, remain skeptical and are forecasting that the pace of expansion will slow as the effects of tax cuts fade, companies pull back in the face of foreign tariffs or a strengthening dollar, and the Fed raises interest rates further. JP Morgan Chase & Co. Chief Economist Michael Feroli expressed he believed it would be hard to repeat this performance on a sustained basis, echoing the reaction of many analysts.2
Although the stock market nudged higher after the GDP report, it certainly didnāt soar. In the midst of all the volatility since February, it still hasnāt gotten anywhere near its peak from
January 26, when the Dow Jones Industrial Average hit 26,616. As Iāve explained before, this is because the value of Trumpās tax cuts has already been factored into the market. Wall Street basically needs the GDP to keep hitting four percent or higher in order for growth to catch up with overvalued stock prices. If that level of growth really isnāt sustainable (as most economists believe), then the only way for the market to make fundamental sense again is for stock values to shrink down to align with corporate earnings. Translation: another major market correction.
This brings us back to the Fedās tightrope act. In their most recent meeting, Fed Chairman Jerome Powell vowed to continue their gradual pace of interest rate hikes, which are supposedly aimed at keeping the economy from overheating. In reality, another important reason for raising rates is so the Fed has some ammunition to lower them again in case of another recession. Yet, moving too fast with rate hikes has the potential to stall growthāin part by continuing to flatten the yield curve.
Stubbornly Low
As I mentioned above, despite nudging closer to 3 percent again in late July, long-term interest rates on the 10-Year Treasury yield have remained stubbornly low despite the Fedās efforts since October to manipulate them upward with the unwinding of our own quantitative easing program. With the Fed funds rate already at 2 percent, hiking short-term rates further will continue to flatten the yield curve, whichāas Iāve explained many timesāhinders one of the most essential elements of economic growth: lending and borrowing.
As long as long-term rates remain stuck below 3 percent, the Fedās tightrope walk will be a tricky one. I believe long-term rates will continue hitting a strong resistance level at just below or above 3 percent for a number of reasons.
Making the tightrope walk even trickier is the fact that Trump openly criticized the Fedās rate-hike policy in a tweet last month. This was a stunning break from historical precedent that some experts believe could shake investor confidence in the Fedās independence. They believe the Fed may feel compelled to restore that confidence by increasing rates more aggressively in defiance of Trumpās criticism despite the risk of stalling growth. āIf anything, the incentive will be to tighten more, not less, because of this political pressure,ā said former Fed economist Roberto Perli.3
Whether that proves to be true or not, many experts continue to maintain that the effort to wean the economy off cheap money and normalize monetary policy again isnāt going to happen without some paināpain that could come in the form of a third major stock market crash, an economic recession, and possibly another full-fledged financial crisis. Do you feel prepared?
- Mark DeCambre, āThe Stock-Market Bull Has Rallied Past One Obstacle After Another,ā MarketWatch, last modified on July 16, 2018, https://www.marketwatch.com/story/stock-market-bull-is-still-on-its-feet-snorting-its-way-past-1-obstacle-after-another-2018-07-14
- Sho Chandra, āU.S. Growth Hits 4.1%, Fastest Since 2014, in Win for Trump,ā Bloomberg, last modified on July 27, 2018, https://www.bloomberg.com/news/articles/2018-07-27/u-s-gdp-growth-hits-4-1-fastest-since-2014-in-win-for-trump
- Pedro Nicolaci da Costa, āTrumpās Unusual Public Criticism of the Federal Reserve Could Have Unintended Consequences,ā Business Insider, last modified on July 23, 2018, https://www.businessinsider.com/trumps-attacks-on-the-fed-could-backfire-with-higher-rates-2018-7
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