Last April I compared the US economy to Boeing’s crash-prone 737 Max, which tries to compensate for an inherent tendency to point its nose straight up by pushing the plane down again with the rear stabilizer. The design is inherently unstable but can be made to appear stable by pushing in opposite directions, until something goes dreadfully wrong.
The US economy (like the whole of the world) is suffering from a political shock, namely a trade war that has frozen capital investment and scrambled business decision-making while the world watches President Donald Trump illustrate his approach to the art of the deal. The economy’s nose keeps pointing down, so the Federal Reserve puts its virtual thumb on the rear stabilizer to push the plane’s nose up again. Real bond yields collapse, so investors move into stocks. The chart below shows that every time the market marked down its estimate of the future Fed overnight rate, the stock market jumped in response.
The trouble is that monetary policy has very little to do with the problem that pointed the nose downward in the first place, namely the trade shock. Financial asset prices have risen but real economic activity continues to look miserable. On Friday, the data service Markit released purchasing managers’ indices for services and manufacturing barely above the zero growth (50%) mark. Even worse, the Markit survey’s index of expectations about future business activity fell much farther than the current activity index.
Note that the bond market’s expectation of 10-year inflation on the US Consumer Price Index has fallen along with Markit’s measures of real output. The sharp fall in expected inflation (measured by the difference in the yields of nominal vs. inflation-linked government bonds) worries central banks. It conjures the specter of Japan, where long-term deflation kept investors hoarding cash rather than investing.
The three regional Federal Reserve banks that have published June surveys all registered sharp declines as well.
The Dallas Fed Index fell even further in early 2016, but that responded to a collapsing oil price.
Collapsing inflation expectations are the central banks’ stated motivation for cutting interest rates. “My FOMC colleagues and I must –and do – take seriously the risk that inflation shortfalls that persist even in a robust economy could precipitate a difficult-to-arrest downward drift in inflation expectations,” Fed Chair Jerome Powell said on June 4. The trouble is that central bank manipulation of interest rates has almost no impact on inflation expectations. Real interest rates (as measured by the yield of inflation-indexed government bonds) have fallen in a straight line with the expected central bank rate. But inflation expectations are all over the map.
The chart above shows the 12th federal funds rate future against real (Treasury Inflation Protected Securities) yields and so-called breakeven inflation, for the period December 1, 2018 to June 24, 2019. As we move to the right on the horizontal axis the expected fed funds rate falls. Real yields move in a straight line with the expected central bank rate. Inflation expectations are all over the map.
This shouldn’t be a surprise. As we saw, inflation expectations have fallen along with real economic activity. Federal Reserve policy isn’t the cause of economic weakness (although President Trump sometimes appears to think that it is). The trade war is the main cause of economic weakness. The Fed can’t fix, but it has no tools at its disposal except the overnight interest rate and the size of its balance sheet. So the Fed continues to ease monetary policy. That has little effect on the slowing real economy (now growing at around 1% a year), but it buoys financial assets. In a June 12 analysis (“Trump’s Moonwalk and the Powell Put”) I discussed some ways in which cheap money lifts equity prices.
This arrangement, like the Boeing aircraft, is inherently unstable. Some analysts think this will end badly. Morgan Stanley’s equity strategists predict that the air will escape from the market, leaving investors with 10% losses in the S&P 500 during the third quarter. There are signs of investor exhaustion. After a spectacular run, the most interest-sensitive sectors of the stock market like consumer staples, utilities and real estate investment trusts have given back a bit of their recent gains. Valuations simply are too stretched in the ultra-conservative part of the stock market for investors to commit more money. I have favored these stocks for the past several months, but it appears that the run is over.
If the stocks that usually respond most directly to Fed easing won’t move, it’s a reasonable surmise that the rest of the market won’t respond to Fed easing, either. At best, the Fed can keep the market treading water.