Charts for the Week
The Federal Debt | A threat to Fed independence
January 27, 2025
Federal Reserve policymakers meet this week for the first time under the new presidential administration. Since September, the Fed has already lowered its target overnight interest rate one percentage point despite the economy supposedly running hotter than it has at any point in the past fifty years and asset valuations at historic extremes.
Nevertheless, President Trump has already indicated he would like the Fed to continue lowering rates despite the bond market having suggested that might not deliver the result he wants. The market is fully priced for the central bankers to mildly disappoint the president by taking a pause on rate cuts this month, but a couple more cuts this year are baked into the expectations of investors who are certain the Fed will protect them from any prolonged pain.
Downward revisions to the economic data could help convince policymakers to give the president and investors the lower rates they desire, hopefully without shaking investors’ optimism. However, the perception that central bankers, the president or investors have of their ability to influence monetary policy for their desired ends may be short lived. The leviathan federal debt holds the catbird seat – a reality that could ultimately leave investors feeling as glum as consumers claim to be.
Source: YCharts, https://fred.stlouisfed.org/ , data.sca.isr.umich.edu , peteratwater.com , AOWM Calculations
Inflation | Not shaking faith in the Fed
January 20, 2025
Despite indicating that annual inflation ended the year trending higher, the latest CPI inflation report was sufficiently better-than-expected to reassure investors that the Fed will not have to reverse course and potentially raise its target overnight interest rate this year to combat sticky inflation. Accordingly, while investors’ inflation expectations did not retreat much, real rates declined to push the benchmark 10-year Treasury yield down to 4.61%.
The inflation of the past few years could have reasonably shaken investors’ confidence in the Fed’s commitment to its 2% inflation target, but that faith has never wavered – at least as measured by long-term inflation expectations revealed in the TIPS market. Instead, investors and policymakers have increased their estimates for how high real rates need to be to contain inflation. That the Fed can and will do what is necessary is not doubted.
Investors' confidence in the Fed's ability to both fend off high inflation and support the financial markets when necessary has underpinned asset valuations for years. However, the burgeoning fiscal imbalances of the federal government increasingly threaten that vital flexibility. The current size of the federal debt likely places a cap on how high real rates can go no matter what inflation does – and the age-old answer to too much government debt has been more inflation.
Source: YCharts, https://fred.stlouisfed.org/ , www.clevelandfed.org/indicators-and-data/inflation-expectations , AOWM Calculations
Rising Rates | Catching investors' eyes
January 13, 2025
In the fall of 2023, the 10-year Treasury yield shot up to 5%, and the stock market had its largest correction of the current bull run. Fed policymakers spooked investors by intimating that they would have to keep short-term rates higher for longer to get inflation under control. In the ensuing months, policymakers pivoted to talking about when they would begin reducing rates, and long-term interest rates quickly retreated below 4% helping to fuel a strong stock market rally in the fourth quarter of that year.
Fast forward 15 months and the 10-year Treasury yield is once again marching towards 5% even though the Fed delivered more reductions in its target overnight rate last year than policymakers had projected to begin the year. Sticky inflation remains part of investors’ concern, but real long-term rates have risen more than inflation expectations. Higher real rates imply a strong economy.
Even if the underlying story remains mixed, the headlines of the latest jobs report on Friday supported the narrative of a good economy about to get supercharged by a business-friendly presidential administration.
While a robust economy would seem to be good news for the stock market, higher long-term rates threaten an elevated market by offering a less risky means for investors to earn a return on their savings. Given the current level of interest rates and equity valuations, a passive investment in the US stock market is unlikely to outperform bonds significantly over the next decade. And the odds that stocks will earn an adequate risk premium only grow longer with every tick higher in long-term rates.
Source: YCharts, https://fred.stlouisfed.org/ , https://shillerdata.com/ , AOWM Calculations
2024/2025 | Review and preview
January 6, 2025
Last year in many ways was a replay of 2023. The year began with expectations that the economy would slow, but corporate profits would still expand strongly while the stock market would have a so-so year as it continued to digest high valuations. However, much like in 2023, GDP growth remained stronger than anticipated, earnings growth missed estimates but remained solid, and the stock market exceeded all expectations pushing valuations higher and higher.
Egged on by the stock market’s positive momentum, prognosticators have banished storm clouds from their 2025 forecasts. Inflation may be a little sticky but remain on a path towards 2%. The economy will continue to grow steadily with nary a hint of recession. The ever-rosy analysts’ projections for earnings are particularly optimistic for next year. And market strategists, after being embarrassingly cautious over the past two years, have thrown caution to the wind with predictions that the booming stock market will continue to boom.
In a typical year, the odds are strongly in one’s favor to anticipate an up year for the stock market which occurs three out of every four years. A presidential election year helps to improve those odds to about six out of seven (likely thanks to some economic juicing by the prevailing powers). In hindsight, that was perhaps a reason to have been more optimistic about the past year for the economy and the market. Looking ahead, though, the first year of a new presidency has historically seen higher odds of a recession and a market downturn, especially if it entails a change of the party in power.
That historical experience coupled with the stock market's elevated concentration and valuation make the tamer projections for the economy and the market of past years seem more apropos for the current one.
Source: YCharts, https://fred.stlouisfed.org/ , www.philadelphiafed.org/surveys-and-data/real-time-data-research/survey-of-professional-forecasters , www.spglobal.com/spdji/en/indices/equity/sp-500/#overview , www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html , AOWM Calculations
Investors | Exuberant by almost every measure
December 30, 2024
Investor exuberance appears to have run off the charts - valuations are at or near record highs, households’ allocations to stocks have never been higher, investor surveys betray a carefree confidence, and the options market has become a borderline casino. Far from climbing a wall of worry, the market currently feels like it is rocketing off a trampoline of endless optimism. The growing fear of missing out is palpable, especially with respect to mega-cap growth stocks that dominate the headline indexes. And yet there are at least a few indicators that investors could get even more exuberant.
For one, investors have not borrowed as much money to buy stocks in the recent run-up as they have in the past. The growing use of options and levered ETFs may be disguising the total leverage in the system. Nevertheless, if the growth in margin debt were to reach the levels seen in 2000, 2007 and 2021, the party will get crazier.
Another indicator that bullish sentiment has not peaked is the relatively low level of initial public offerings (IPOs). Peak investor enthusiasm usually engenders a lot of IPOs as companies take advantage of the strong demand for stocks. Uncertainty about the election and structural changes in the economy may partly explain the lack of IPOs; however, it would be an anomaly for the market to roll over before there is a burst of IPO activity (granted anomalies have become less anomalous in recent years).
Barring a technological miracle that is hard to fathom even in an AI world, a passive investment in the US stock market has long since passed the point of offering good returns for a buy-and-hold investor. That does not mean FOMO can’t carry us to new extremes. Record valuations are only reached by exceeding the previously unthinkable.
Source: YCharts, https://fred.stlouisfed.org/ , shillerdata.com , https://site.warrington.ufl.edu/ritter/files/IPO-Statistics.pdf , https://www.citizensbank.com/corporate-finance/insights/private-equity-trends , https://www.tuck.dartmouth.edu/news/articles/where-did-all-the-public-companies-go , AOWM Calculations
More Monetary Easing | Too much of a good thing?
December 23, 2024
The Fed reduced its target overnight interest rate last week by another 0.25 percentage points, but investors were not grateful. The S&P 500 Index fell almost 3% while the 10-year Treasury yield jumped back over 4.5%. Changes in the Fed’s economic projections drove the negative market reaction.
In September, policymakers projected they would cut the fed funds rate another 100 basis points (i.e., 1 percentage point) next year as they have done over the past few months, but last week they dialed that back to just half a percentage point. It hardly seems worthy of a market tantrum, especially as policymakers are still forecasting a reduction in the real fed funds by more than 50 basis points next year, similar to their projection in September.
While market expectations for long-term inflation continue to reflect a high degree of investor confidence in the Fed's inflation fighting credentials, could investors be starting to question the wisdom of cutting rates with inflation sticky and markets exuberant? Could they be starting to see monetary stimulus as too much of a good thing? Probably not - likely just ever greedy for more whether wise or not. But that day may yet come.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
Yield Curve Uninverted | What now?
December 16, 2024
The Fed has its last meeting of the year this week, and the market is priced for another reduction in the Fed’s target overnight interest rate. As the Fed has been cutting short-term rates in recent months, long-term rates have been rising and shot higher again last week. On Friday, the 3-month Treasury yield finally fell back below the 10-year yield after more than two years of being inverted – the longest such inversion since the 1920s.
Over the past half century, an inversion of the yield curve had been a reliable indicator that a recession was on the horizon, and the reversion back to its normal upward slope a sign of an imminent downturn. However, as the inversion dragged on and economic growth remained strong, faith in the predictive powers of the yield curve faded. If the economy continues to hum along over the next year, this time will have proven to be different.
Nevertheless, policymakers still – perhaps wisely and despite what they say – don’t really seem to believe it’s true. For if the economy is great, there is dubious rationale for cutting rates when inflation remains above target and asset valuations are at potentially destabilizing extremes. And indeed, the Fed may be done with rate cuts after this upcoming meeting if the economy is in fact healthy and elevated inflation persists. Or the warnings long imbedded in the yield curve may yet be proven out via future data revisions that reveal an economy weaker than currently thought and calling for monetary stimulus.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.htm , AOWM Calculations
The Outlook | Confusing as ever
December 9, 2024
Last week, the Chair of the Federal Reserve proclaimed the economy to be in very good shape, and the S&P 500 notched four new record highs. Everything appears awesome. And yet, interest rates fell as investors increased their expectations for looser monetary policy to help stimulate the economy that is supposedly doing so well, and the equal-weighted S&P 500 declined on Monday, Tuesday, Wednesday, Thursday, and Friday as the stock market rally narrowed once again.
Policymakers and investors appear as confused as the jobs report, which continues to paint a picture of a labor market that is stagnating despite solid economic growth. Payrolls rebounded nicely in November, but the recession-resistant Government, Education and Health Services sectors continue to be the primary drivers of job growth – not historically a good sign. The unemployment rate also ticked up slightly to 4.2%, and the number of individuals in full-time employment remained lower than it was a year ago.
Despite the recurring warning signals in the labor market data and the expectations for the Fed to ease monetary policy like a downturn is imminent, a recession next year would be surprising based purely on the strength of the stock market. The forward-looking stock market does not usually decline significantly before a recession starts; however, the uptrend does typically slow as a downturn approaches, and we have yet to see that.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
Historical Parallels | Entertaining caution
December 2, 2024
It was a year of discontent. Despite solid economic growth, low unemployment and a strong stock market, the people were unhappy. A foreign war of containment and rising consumer prices helped to sour the mood. The president – a long-time Democratic senator who had served as vice president and ultimately made it to the mountain top on his own – was unpopular; well into the election year, he decided not to run for re-election. His vice president, promising to bring back the joy, was effectively handed the nomination at the Democratic National Convention in Chicago. The election was close, but the Republican candidate whose political obituary had been written many times eked out a comeback victory on election day, November 5. The stock market cheered the election results and rallied to hit a new all-time high on the day after Thanksgiving, November 29. However, Warren Buffet grew increasingly defensive in the face of rising equity valuations.
The year was 1968… and 2024. The entertaining parallels with the past aside, human nature does sway history – and the markets – to progress with some cyclicality. Actions engender reactions which provoke actions. That doesn’t mean we are about to relive the 1970s, but it is a cautionary tale against betting the house on endlessly smooth sailing.
If the new year brings tougher economic conditions with less government support and a retreat in animal spirits, it will be an old story. But it will not be the end of the story. After all, Warren Buffett closed his investment partnership in 1969 in reaction to “an increasingly short-term oriented and more speculative market,” and he ended up doing all right retreating to the management of a failing textile manufacturer.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
Tariffs | Unintended consequences
November 25, 2024
The exuberant stock market is indicative of the high hopes for the incoming administration with investors discounting Trump’s more disruptive proposals as campaign rhetoric unlikely to be implemented. For example, Trump has proposed imposing 10% to 20% tariffs on all imports and 60% tariffs on Chinese goods which, if effected and sustained, would reduce the trade deficit in a way investors are unlikely to appreciate.
The Constitution gives Congress the power to set tariffs; however, in the decades following the Great Depression through the 1970s, Congress delegated broad authority to the president with respect to international trade. Whether Congress can or has granted the president the authority to set indiscriminate tariffs is debatable. Nevertheless, given the unsuccessful legal challenges to the tariffs imposed in Trump’s first administration and continued by Biden, it seems likely that, if Trump decides to impose tariffs on all imports, he will be able to do so without Congress unless the Supreme Court ultimately decides to weigh in otherwise.
While the trade deficit needs to be addressed, doing so also means reducing the support our financial markets have enjoyed for decades from the persistent inflow of foreign capital. It is a chicken-and-egg story as to whether foreigners’ desire to invest in the US generates the trade deficit or our hunger for imported goods effectively draws in international capital. Either way, they go hand-in-hand; thus, a policy that decreased the trade deficit would also decrease the flow of international capital into the US at a time when domestic savings is minimal.
In addition to reducing the demand for US assets, any inflation generated from new tariffs would be another unintended consequence that could further upset financial markets priced for perfection. And then there are the innumerable unknown disruptions such a shock to the system might bring about, which is understandably all the more reason why investors can’t contemplate the tariff talk in its most extreme form as more than mere bluster.
Source: YCharts, https://fred.stlouisfed.org/ , https://taxfoundation.org/blog/trump-tariffs-revenue-estimates/ , https://budgetlab.yale.edu/research/fiscal-macroeconomic-and-price-estimates-tariffs-under-both-non-retaliation-and-retaliation , AOWM Calculations
Soft Landing | Have we arrived?
November 18, 2024
The incoming economic data continues to be generally good, and last week the Chair of the Federal Reserve indicated that policymakers are not in a rush to cut rates further. If the Fed has successfully brought inflation to heel without a recession, then it may be closer to being done lowering short-term rates than investors suspected just a few weeks ago, and long-term rates may have further to rise.
In the mid-90s, when the Fed last engineered a soft landing, it only reduced its target overnight interest rate by 0.75 percentage points as the economy and markets remained strong. Thus far this time, the Fed has once again eased by 0.75 percentage points, but policymakers are inclined to go further even though the economy seems to be growing steadily, inflation remains above their target, and asset valuations are at historical extremes.
Before fully declaring success, policymakers likely want to see the labor market stop losing altitude with each passing month. No matter what the labor market does, sticky inflation could get in the way of significantly more monetary easing. Although, the powers-that-be have gotten good at explaining away recent inflation as a never-ending series of one-off events that can be disregarded.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
New Old Regime | Same enduring challenges
November 11, 2024
Last week was a good one for the stock market. The election was clearly decided before the next business day even began eliminating concerns of a contentious, prolonged battle, and the Fed continued to ease monetary policy by lowering its target overnight interest rate another quarter percentage point. The reduction in uncertainty, the potential for more corporate-friendly government policies, and looser monetary policy boosted the broad market indexes to new all-time highs.
The market reaction to the election was not uniformly positive. International stock markets were subdued as clouds formed over the future of global trade, and long-term interest rates initially spiked higher on concerns about what the new administrations’ policies might mean for the federal debt and inflation. Inflation expectations have been creeping back up even as the Fed has essentially declared victory. Investors have at least begun to hedge how far and fast they think the Fed will cut rates which is a combination of greater confidence in the economy and fears about inflation.
As for the US stock market, the pre-election exuberance was already a tall order to meet before last week’s melt-up. The new administration faces enduring challenges for which there are no easy solutions. When that reality hits home, investors will likely have to recalibrate their expectations. Until then, irrational exuberance can continue to unduly escalate asset values (to borrow Alan Greenspan’s turn of phrase).
Source: YCharts, https://fred.stlouisfed.org/ , www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html, AOWM Calculations
Election Year | Uncertainty that markets love?
November 4, 2024
In theory, uncertainty should increase risk premiums and serve as a headwind to asset price appreciation. However, leading into a highly uncertain election, the stock market has soared. Through October 29, the S&P 500 had returned nearly 44% over the past year which is in the top 2% of annual returns since 1950. Even after cooling slightly in recent days, the market is still having its best year leading into a presidential election in modern history.
While the strength of the rally is surprising, most election years have not been bad for the market. Indeed, valuations have risen over the year preceding a presidential election far more often than not. They have certainly done that again this go-around with the valuation of the S&P 500 stretching to historical extremes.
The strength of the stock market does not tell us much about who will win the election, but whoever does win will inherit market expectations that will be challenging to meet.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
The Fed | Getting ready to pull the other lever?
October 28, 2024
Since the Fed’s rate cut of 50 basis points last month, the case for swiftly easing monetary policy has faded pushing up long-term rates and quickly steepening the yield curve. While the market is still priced for further rate cuts in the coming months, lowering the Fed’s target overnight interest rate is not the only lever policymakers have to pull. In the age of supersized central bank balance sheets, when to cease shrinking the Fed’s holdings of US Treasury debt and mortgage securities is another key policy decision.
The Fed slowed its Quantitative Tightening earlier this year but has continued to reduce its balance sheet even as it has shifted to lowering interest rates. Reverse Repurchase Agreements (Reverse Repos) have been the primary liability on the Fed’s balance sheet that has declined over the past year in step with the decline in the Fed’s assets. After peaking at $2.4 trillion, the Fed’s reverse repos are now down to $258 billion – the lowest level since May 2021.
In a reverse repo, money market funds and other market participants loan money to the Fed using the Fed’s Treasury holdings as collateral. As a result, the decline in the Fed’s reverse repos is driven by market participants moving their money into more traditional US government debt (which the Fed is no longer buying as much of as it shrinks its balance sheet), so there is little potential for market or economic disruption. However, as reverse repos dwindle, further reductions in the Fed’s balance sheet are likely to start reducing bank reserves which has a greater risk of upsetting the delicately stacked apple cart.
Stopping the reduction in the Fed’s balance sheet could also ease some pressure on long-term interest rates which have thus far counteracted the Fed’s initial move to ease monetary policy. Thus, for many reasons, an announcement that lays out the Fed's plans for winding down its Quantitative Tightening seems likely before the end of the year. If so, the Fed’s balance sheet will once again be left far larger than it was before the crisis that precipitated its massive expansion – a decision that is not without its own perils.
Source: YCharts, https://fred.stlouisfed.org/ , www.fdic.gov/quarterly-banking-profile/fdic-quarterly-banking-profile-archived-issues , AOWM Calculations
Federal Finances | Precariously profligate
October 21, 2024
Last week, the US Treasury reported that the federal government ran a deficit of $1.8 trillion for the 2024 fiscal year that ended in September. As a percentage of the nation’s economic output, the federal deficit remains elevated at approximately 6.5% of GDP despite solid economic growth and low unemployment. High structural deficits driven by the increasing costs of mandatory spending, such as Social Security and Medicare, have been compounded over the past couple of years by the rising net interest expense on the burgeoning federal debt. More than 27% of the federal budget last year was paid for with borrowed money.
Over the past three years, the federal debt held by the public has increased by roughly $2 trillion each year which has pushed the national debt back towards 100% of GDP. Without a change in policy, the federal debt is expected to continue swiftly growing relative to the size of the economy even if economic growth remains strong. Interspersing a mild recession at some point over the next decade would only exacerbate the problem that is hindering the long-run growth potential of the economy and risks engendering higher inflation and/or interest rates. And a deeper economic downturn could find the federal government without the flexibility to respond like it did after the financial crisis in 2008 and the pandemic in 2020 given the current size of the debt.
Despite the clear and present risks posed by the state of federal finances, little care is being paid to the issue (and in many ways the opposite). Even though the net interest expense on the federal debt as a percentage of GDP has rocketed back to where it was in the 80s and 90s when there was significant societal anxiety about the deficit, the issue is absent from the national dialogue today. That is likely to remain the case until either the financial markets focus the minds of Congress, or the electorate no longer views profligate federal finances as a free lunch.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.cbo.gov/data/budget-economic-data#3 , AOWM Calculations
Investor Sentiment | Too hot?
October 14, 2024
CPI inflation came in higher than expected in September, but that did little to alter the narratives driving the stock and fixed income markets. Bond investors still anticipate the Fed will ease monetary policy aggressively over the next year, and stock investors still see nary a cloud in the sky.
Even if the economy has entered a Goldilocks state, the current enthusiasm for equities risks being dangerously hot. The nation’s Financial Accounts indicate households are allocating a record amount of their financial assets to stocks. In addition, the number of investors professing concerns about the market’s prospects has dwindled, and the options markets - which investors increasingly use to lever their bets - remain largely priced for the good times to keep on rolling over the next year. Such lopsided positive sentiment has often been followed by weak returns.
One potential sign that some investors may be starting to grow a little wary of the stock market’s run to ever higher valuations is the uptick in the “fear” index of expected market volatility over the next 30 days even as the S&P 500 has hit several new all-time highs. But that may be driven more by concerns around the upcoming election than actual fears of a market downturn. If the uptrend in the VIX index continues through earnings season and past the election, that will be a more telling warning about the strength of investors’ animal spirits.
Source: YCharts, https://fred.stlouisfed.org/ , www.minneapolisfed.org/banking/current-and-historical-market--based-probabilities , shillerdata.com , www.aaii.com/sentimentsurvey/sent_results , AOWM Calculations
Economic Data | Positively surprising
October 7, 2024
Recent economic data has been surprising on the high side, suggesting the economy is holding up well. That positive data includes the latest jobs report in which the unemployment rate declined for the second month in a row to 4.1% in September and employers added more jobs than expected. With the labor market appearing stronger than feared, long-term interest rates increased last week, and investors pared back expectations for Fed rate cuts.
While it is the market’s nature to react to every bit of news, the jobs report is inherently volatile, especially the payroll data which is subject to significant future revisions. Little in the report clearly changed the picture of a labor market that is oddly stagnate – neither really expanding nor shrinking. The year-over-year growth trend in the payroll data is still slowing, and the internals of the Establishment Survey remain full of cautionary signals – e.g., the decline in the number of temporary workers persists, and a large percentage of the job gains over the past year have been generated by the government and private education & health services sectors (historically an indicator of economic weakness). The Household Survey also continues to show no growth in total employment over the past year and shrinking full-time employment.
Nevertheless, the recent economic data supports expectations for solid earnings growth in the third quarter. Beyond that, continued economic strength will be essential for companies to achieve the anticipated growth in profits over the next year; even then, it may not be enough to fulfill the hopes and dreams imbedded in the stock market’s current valuation.
Source: YCharts, https://fred.stlouisfed.org/ , www.spglobal.com/spdji/en/indices/equity/sp-500/#overview , AOWM Calculations
Bean Counters | Find some missing beans
September 30, 2024
The economic data has been confusingly conflicting for some time. The Bureau of Economic Analysis (BEA) fixed part of that problem last week with its latest annual update of the National Economic Accounts. Gross Domestic Income (GDI) had been indicating a less robust economy than Gross Domestic Product (GDP) with the statistical discrepancy between the twin measures of the economy having grown to a historically wide level. The BEA reconciled that by unexpectedly – and not particularly explicably – increasing its estimate of GDI by a historically large amount.
GDP and GDI now tell a consistent story of an economy growing briskly. With the unemployment rate still low (if rising) and inflation falling (if still higher than desired), the economy appears to be in a goldilocks state, which could support the strong earnings growth baked into current stock prices.
And yet, fixed income investors still expect deep interest rate cuts by the Fed over the next year - which would be odd if the latest revisions to the National Accounts are accurate. Consumer sentiment also continues to languish at an unusually low level given the apparent strength of the economy, and employment growth is incongruently low for an economy reportedly growing above its long-run potential. All the mysteries have not been solved and in some ways have been made more mysterious by the new uniformity of the GDP and GDI data. We but see in a mirror dimly.
Source: YCharts, https://fred.stlouisfed.org/ , www.bea.gov/data/gdp/gross-domestic-product , https://data.sca.isr.umich.edu/ , AOWM Calculations
Asset Prices & Monetary Policy | Unspoken dilemma
September 23, 2024
On September 18, 2024, the Fed lowered its target overnight interest rate from 5.33% to 4.83% after having held rates steady for nearly 14 months. On September 18, 2007, the Fed lowered its target rate from 5.25% to 4.75% after having held rates steady for a little more than 14 months. Central bankers are clearly not afraid of letting the present more than rhyme with an unpleasant past.
Given the ineffectiveness of historical analogs to predict anything in recent years, policymakers likely feel they are safe. In fact, while their first 50 basis point move was on the high side of market expectations and they increased their anticipated pace of rate cuts in coming months, Fed officials remain more sanguine than fixed income investors who continue to project recession-esque monetary easing taking the fed funds rate below 3% over the next year. Far from forecasting a recession, policymakers foresee tranquil sailing for the economy with steady 2% growth over the next few years accompanied by a stable unemployment rate and inflation close to their 2% target. The odds of the future being so perfectly placid are low.
Whether the monetary powers-that-be are overstimulating a strong economy or trying to prop up a stalling one, time will tell. There is ample data to support both possibilities. Over the past three decades, employment growth has never been as weak and GDP growth has never been as strong at the start of a Fed easing cycle as today. Also on the side of potentially overheating, though policymakers are rarely quizzed about it these days, asset valuations have never been so uniformly elevated as they currently are when the Fed has begun reducing rates in the past.
Volumes have been written on whether central bankers should take asset prices into account when setting policy. After forty years of market friendly monetary policy, the question is assumed answered. However, the dilemma still exists even if it is left unspoken. While policymakers are ill-advised to attempt to use monetary policy to normalize elevated asset valuations, ignoring frothy market conditions is also questionable.
Source: YCharts, https://fred.stlouisfed.org/ , BLS , shillerdata.com , www.federalreserve.gov/monetarypolicy.htm , https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html , AOWM Calculations
Game-time Decision | Unusual Fed uncertainty
September 16, 2024
Emergency actions aside, usually before Fed policymakers act, they have molded market expectations sufficiently that there is minimal surprise. When the Fed announces its next move on Wednesday, the consensus firmly anticipates a reduction in the target overnight interest rate, but the size of the cut is uncertain.
Perhaps policymakers themselves don’t yet know whether they will reduce their target rate by 25 or 50 basis points. The economic and market data are full of sufficient incongruities to justify making it a game-time decision. However, the size of the initial move is unlikely to be as important to investors as policymakers’ revised projections for the fed funds rate over the next year.
Back in June, policymakers expected to make only one 25 basis point cut this year and for the fed funds rate to still be above 4% by the end of 2025. Investors are currently expecting the overnight interest rate to be below 3% by the end of next year - a velocity of monetary loosening typically only seen during a recession. Needle-threading policymakers will likely project faster rate cuts than they did in June but fewer than the market is expecting in the hopes of not raising suspicions that their soft landing is in doubt.
Source: YCharts, https://fred.stlouisfed.org/ , BLS , https://www.spglobal.com/spdji/en/indices/equity/sp-500/#overview , www.philadelphiafed.org/surveys-and-data/real-time-data-research/survey-of-professional-forecasters , AOWM Calculations
September | Mr. Market's seasonal mood
September 9, 2024
September is the only month for which the stock market has a losing record. After the first week of the autumnal transition, stocks are not off to a good start for improving that winning percentage this year. Markets are pulling back for the second time in as many months on renewed concerns about the economy and fears that sky-high AI expectations may be too optimistic.
Whether this proves to be merely another seasonal mood or a more prolonged correction will depend on how justified those concerns and fears prove to be. While the Fed will very likely begin lowering its target overnight interest rate next week, economic activity still seems poised to slow in the coming quarters which may make lofty profit expectations hard to achieve.
Following the jobs data released last week, leading indicators and prevailing trends continue to point towards further weakening. That has been true for a long time as the slowdown in the labor market has proceeded at a deliberate pace over the past two years; however, downward momentum is building into a fragile environment.
Source: YCharts, https://fred.stlouisfed.org/ , BLS , AOWM Calculations
Yield Curve | Shifting from watch to warning
September 2, 2024
Last week, for the first time in over two years, the yield on the 2-year Treasury Note fell below the yield on the 10-year Treasury Note. If the inversion of the yield curve is the equivalent of a weather watch for the economy, the reversion of the yield curve to its normal upward sloping shape has historically been the warning of imminent storms.
The yield curve – the line drawn through the interest rates of US Treasury securities with different maturities – is primarily a reflection of expectations for future monetary policy. It is currently indicating a level of monetary easing over the next year that would be unlikely absent a downturn in the economy.
The behavior of the stock market and recent GDP data are greatly at odds with that outlook. However, the latest estimates of Gross Domestic Income and the labor market paint a picture of a weaker economy that could justify expectations for looser monetary policy. In addition, net domestic savings has now remained negative for six straight quarters - a persistent imbalance that will impede economic growth in the coming years.
The early warning signals for the economy are even less precise than those for the weather but still worthy of attention.
Source: YCharts, https://fred.stlouisfed.org/ , BEA , AOWM Calculations
Rate Cuts | The time has come
August 26, 2024
In a speech last week, the Chairman of the Federal Reserve, Jerome Powell, seemed to all but guarantee a reduction in the overnight fed funds rate when policymakers next meet in September. Additional inflation and labor market data will supposedly determine how big the September cut will be and how quickly more cuts will follow. The Fed has already let the labor market weaken more than it has done in recent decades before cutting rates, but inflation also remains higher than it has been historically when the Fed has started to loosen monetary policy.
Before Powell spoke last week, the Bureau of Labor Statistics released its preliminary annual benchmark revision to the March payroll estimate which provided further evidence the labor market is slowing to a crawl. Payrolls in almost all sectors were revised lower, and total payrolls were estimated to be 0.5% smaller in March than previously reported. Given the further deceleration of the labor market in recent months, Fed policymakers are likely growing anxious that the lagged effects of tight monetary policy are beginning to be felt despite other data showing the economy remains strong.
Higher-than-desired inflation may keep the Fed from aggressively reducing short-term rates as long as the economy generally appears healthy. A clearly weakening economy would provide policymakers with the rationale for faster rate cuts even if inflation remains above the Fed’s target and could also provide the cover for an ultimate acceptance of higher long-run inflation - which seems almost inevitable given the fiscal challenges facing the federal government.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.bls.gov/web/empsit/cesprelbmk.htm , https://www.bls.gov/web/empsit/cesbmkarch.htm , AOWM Calculations
Profit Margins | Good news, bad news
August 19, 2024
Annual CPI inflation in July fell below 3.0% for the first time since March 2021, providing fresh support for the soft-landing narrative. The financial markets are now pricing in rapid, deep cuts in the fed funds rate (typically only seen if the economy is entering a recession) and swift growth in corporate profits. For the earnings expectations to be accurate, investors will likely need to once again be proven overly aggressive in their rate cut forecasts.
Earnings growth expectations also continue to appear aggressive in their own right even if the economy remains healthy. Earnings for the S&P 500 have trended sideways for the past three years but are anticipated to resume a strong uptrend in the coming quarters based on profit margins trending higher as well.
Corporate profit margins were a relatively stable, mean-reverting variable during the second half of the last century. However, over the past several decades, corporate America has enjoyed having an increasing amount of revenue fall all the way to the bottom line. It is a trend that would seem unlikely to continue with the tailwinds of declining interest rates and lower taxes having abated.
The good news for investors is that margins may not revert to their 20th century level. The bad news is that may be because higher margins have been justified by the downshift in economic growth experienced over the past 25 years. If the owners of capital are not compensated with growth, they in theory may take a larger piece of the economic pie to achieve their target returns.
Investors are prone to extrapolate the recent trend in profit margins ever higher and to use that growth to justify higher valuations. But if the move to elevated profit margins has been the result of the transition to a slow growth world, margins will not continue to expand (unless economic growth grinds even lower), and valuations may be more stretched than history would suggest.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.spglobal.com/spdji/en/indices/equity/sp-500/#overview , https://www.hussmanfunds.com/research/rs240805/ , AOWM Calculations
Global Financial Markets | Signs of fragility
August 12, 2024
The financial markets suffered a brief spasm of concern last week. Continuing the selling pressure from the previous week, global equity markets sold off last Monday with the Japanese stock market down over 12% for the day. Credit spreads on corporate debt began to increase, and the expected volatility in the US stock market spiked to levels only seen during the financial crisis of 2008 and the pandemic. By Friday, however, things had largely returned to where they were before the week began.
On top of the weak jobs report in the US, the apparent spark for the excitement was the Bank of Japan which boldly raised interest rates by 0.15 percentage points, indicated more small hikes may be in the offing and laid out a plan to begin slowly reducing its enormous balance sheet. Real, inflation-adjusted interest rates in Japan are still deeply negative as its monetary policy remains highly accommodative; however, the rate hike was not fully expected by the market and clearly surprised some investors who were counting on Japanese interest rates remaining near zero. Policymakers in Japan quickly provided assurances that they would not be overly hasty in making policy less accommodating if volatility persisted, which calmed the market tantrum.
Central banks around the globe have spent the past several decades suppressing market volatility as much as possible. As last week’s rollercoaster suggests, investors are still betting on them being able to do so going forward. And yet, the recent events in Japan may be an early indication that won’t be the case as central bankers are increasingly caught between a rock and a hard place (partly of their own making) that will prevent them from trying to make every crooked path straight.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.global-rates.com/en/interest-rates/central-banks/9/japanese-boj-overnight-call-rate/ , https://www.boj.or.jp/en/mopo/mpmdeci/mpr_2024/index.htm , AOWM Calculations
Recession Fears | Reawakened
August 5, 2024
Two weeks ago, good GDP and inflation reports offered more hope the Fed would avoid tipping the economy into a recession in its battle to rein in rising consumer prices. Just a week later, markets were gripped with renewed concerns about the strength of the economy as the unemployment rate ticked higher for the fourth consecutive month.
As expected, policymakers at the Fed did not lower their overnight interest rate last week but affirmed that they are inclined to do so in September. The stock market initially met that with enthusiasm. Then the jobs report fostered fears that the economy may be weakening faster than the Fed or investors anticipated.
In general, the labor market appears healthy. Payrolls continue to grow, and the unemployment rate remains historically low; however, the trend is negative and suggests the economy is weaker than the GDP data implies. Long-term Treasury yields plunged back to where they were at the end of last year when investors were expecting the Fed to aggressively cut short-term rates this year. That expectation has been revived, but this time with concerns the Fed’s actions may be driven more by a weak economy than benign inflation.
Source: YCharts, https://fred.stlouisfed.org/ , Google, AOWM Calculations
The Fed | To cut or not to cut?
July 29, 2024
Fed officials will meet again this week to contemplate the future direction of monetary policy. The consensus is policymakers will lay the groundwork to begin lowering their target overnight interest rate when they next meet in September. However, a muddled economic picture may prevent them from significantly reducing rates in the coming months even if an initial cut is made in a few weeks.
Weighing in favor of beginning to loosen monetary policy is relatively benign inflation over the past quarter and a weakening labor market. On the other hand, GDP growth appears to be accelerating, inflation remains above the Fed’s 2% target, asset valuations remain elevated, and the current fed funds rate is not excessively restrictive. Thus, the Fed risks another wave of high inflation if it loosens too much too soon.
Policymakers always aim for a soft landing but rarely achieve it because deciphering the direction of the economy in real time is not easy. That is perhaps even more true today than in the past.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
Consumers | Beginning to align words and deeds?
July 22, 2024
With the commencement of earnings season, investors' anxiety is again on the rise. Expected market volatility, as implied by options on the S&P 500 Index, spiked higher last week. Earnings reports so far have been generally positive, but it is early, and investors may place more importance on how management teams feel about the rest of the year when earnings are forecasted to grow quickly.
Early indications from management conference calls suggest that consumer spending is slowing. A slowdown has been anticipated for a long time, but consumers have kept on spending despite expressing a dour outlook when surveyed. A softening labor market, dwindling pandemic savings, and high inflation may be starting to align consumers’ words and deeds.
Leading economic indicators also continue to decline and portend an economic slowdown. However, that has also been true for the past two years, and the pace of decline in leading indicators is slowing while current economic data remains largely "resilient". Thus, if there is a recession in the near future, it may be a mild one. But, much as was the case after the market peak in 2000, that may not save an overpriced market - at least not the headline, market-cap-weighted indexes. If the economy keeps motoring, the large portion of the stock market that has been left behind by the mega-cap stocks could shine as they did after the dot-com bubble and once again highlight the long-run benefits of slow and steady.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.conference-board.org/topics/us-leading-indicators , AOWM Calculations
Source: YCharts, https://fred.stlouisfed.org/, BLS, www.global-rates.com/en/interest-rates/central-banks/, www.economist.com/economic-and-financial-indicators/2024/06/06/economic-data-commodities-and-markets, AOWM Calculations
The Economy | Latest news, old news
June 3, 2024
The government’s latest official read on the state of the economy was a continuation of recent trends with steady growth and strong corporate profits belied by statistical discrepancies and cautionary imbalances.
For the second consecutive quarter, the average of Gross Domestic Product (GDP) and Gross Domestic Income (GDI) indicated that the economy expanded by a solid 2.4% over the past year. GDP continues to measure noticeably larger than its twin, GDI; however, the statistical discrepancy is no longer growing and both measures of the economy are now trending in the same direction.
Last week’s report also showed persistent strong corporate profitability with profits continuing to account for an elevated share of national income. Despite corporations’ success in taking more of the economic pie over the past decade, it remains risky to declare that profits have reached a permanent new plateau as a share of national income given rising interest rates and the fiscal imbalances facing the federal government that will likely require higher taxes. Those imbalances are highlighted by the fifth consecutive quarter of negative net domestic savings which threatens to reduce the long-run growth potential of the economy.
One new item of note: nominal year-over-year GDP growth decelerated to 5.38% after the recent revision and is now basically equal to the Fed’s target overnight interest rate. Economic growth and the long-run level of interest rates are linked; thus, it is notable when the fed funds rate crosses paths with GDP growth. Excluding the pandemic, nominal GDP growth has typically fallen below the fed funds rate before or around the start of a recession. That has not happened yet and may not if the Fed starts to lower rates before the end of the year.
