As you most likely know, last Friday’s strong jobs report – which showed 224,000 jobs created in June – has caused a bit of unease across the market. With investors now salivating over the prospect of a rate cut, robust economic data has come to be viewed with disdain. After all, who wants a strong economy when we can have asset-price juicing stimulus instead?
What annoys me is that both of these outcomes have the prospect of lifting stock prices, one just usually operates much faster than the other. Organic economic growth takes time to work its way into earnings, and therefore the climb higher for stock prices is gradual.
Rate cuts, on the other hand, reduce the cost of money and tend to drive a psychological reaction among investors that can lift both spirits, and the market, quickly. Ultimately, the intended result of rate cuts is stronger economic growth, but why have only one when we can have both?
Even with June’s employment report showing the best job growth of the year, the market (based on fed funds futures) is still predicting a 100% chance of a rate cut later this month. The only thing that really shifted was a reduction in the number of bets that the Fed would cut by 50 basis points instead of 25.
If you ask me, this is ludicrous. Real GDP growth in the 1st quarter was 3.1%, it’s expected to be 1.7% in the 2nd quarter (roughly matching the estimated long-run growth potential of the economy), and the economy is creating many more jobs than needed each month to maintain full employment. Add in that wages are up 3.1% over the past year, consumer spending is up 4.2%, business spending is up 5.9% (through the 1st quarter) and I ask you: where’s the justification for a rate cut?
Oh yeah … inflation and global growth. Let’s attack each of these separately.
Regarding inflation, let’s be honest here – core Personal Consumption Expenditures (PCE), the Fed’s preferred measure of inflation, isn’t that far below target. It was up 1.6% year-over year through May, and more importantly, it hasn’t been below 0.9% at any point during the last two decades, even at the depths of the financial crisis.
As you can see above, the Fed has a hard time influencing core inflation no matter what they do. Recall that rates were as low as 1% in 2004, rose to over 5% by 2006, fell to 0% by 2009, and now sit just over 2%. During all of that, core inflation has moseyed along in a range of 1-2%. Does it really make sense for the Fed to use one (or possibly two) of their 9 remaining bullets here, when the only real justification for lower rates is something the Fed has little control over anyway?
Also, it’s important to recognize just how much stimulus has already come into play based on market action. In the chart below, we can see that rates across the entire yield curve have fallen substantially this year. This, by itself, is a tremendous amount of stimulus, and I would argue it’s a lot more stimulus than a 25 or 50 bps rate cut would be, since rates at the long end of the yield curve have fallen substantially as well (the entire objective of QE).
And if it’s true that monetary policy “acts with a lag” then we have not yet seen all the benefits from the reductions in interest rates seen above. That stimulus is still moving through the system.
Now, there are two more things we need to consider. The first is global growth, as mentioned above. Global growth has been stalling, and this is a valid concern. However, the Fed’s dual mandate includes no mention of propping up the global economy, it only entails maintaining full employment and price stability here in the States.
Obviously, global economic conditions impact us, as all major economies are deeply interconnected, but the U.S. economy still remains heavily driven by domestic demand. We are not an export driven economy and as long as domestic consumers and business remain healthy, we can most likely weather a temporary downturn overseas. Recall that the global economy experiences much more frequent recessions than the U.S. does.
Moving on, the other consideration is this: All of the healthy economic data points I mentioned above are coincident or lagging indicators. They tell us where the economy has been, not where it’s going. In terms of leading indicators, there is more to be concerned about … but not that much. Let’s go over some of these now.
Jobless claims, one of the most timely leading indicators since it’s released weekly, still remain near multi-decade lows.
The number of temporary workers, which typically falls before a recession (since these are usually the first folks to go) is holding steady.
The quit rate, which also falls when workers recognize a deteriorating labor market, remains in an uptrend.
Heavy Truck sales, which reliably fall off a cliff ahead of approaching recessions, have not fallen off the cliff yet.
And ISM services, a key gauge of non-manufacturing demand, remains solidly in expansion territory (above 50%).
Now, this is obviously not a complete list, and there are a handful of leading indicators (which we’ve covered in previous articles) that are showing deterioration. However, many of these involve readings on manufacturing, which, according to the Bureau of Economic Analysis, only accounts for 11.6% of the economy.
The net result of all this can be captured by taking another look at The Conference Board’s Leading Economic Index (pictured below), which is a composite of 10 leading indicators. The takeaway here should be that while conditions aren’t necessarily great, they’re also not deteriorating sharply either. Rather, we simply appear to be in a period of moderating growth.
Thus, I can’t help but feel there is little justification for a rate cut later this month. But justification or not, I have a feeling we’re going to get one, simply because the market is demanding it by their positioning in the fed funds futures market. With 100% of market participants expecting a rate cut, the Fed is somewhat boxed into a corner, knowing that they’ll take an awful lot of flack if they don’t deliver.
As I see it, the only way for the Fed to work themselves out of this is to reset expectations before the upcoming blackout period. Mr. Powell is set to deliver remarks to Congress on Wednesday and Thursday, and if he is going to try and signal different intentions to the market, this is where it will happen.