The April 10 FOMC minutes confirmed a rate hike pause and reiterated concerns about a slowdown in U.S. economic growth, a weaker global economy, and U.S.-Chinese trade tension. According to the minutes, "A majority of participants expected that the evolution of the economic outlook and risks to the outlook would likely warrant leaving the target range unchanged for the remainder of the year."
We are currently at an interest rate inflection point. If the global economy strengthens again, the Fed will continue interest rate hikes with a goal of reaching at least 5%. If it does not, they will cut. With an inverted yield curve signaling weak market expectations and a continued influx of weak economic data (especially from Europe and China), I believe the next move for rates will be lower. In fact, the CME FedWatch Tool targets the probability of easing by January 2020 at 54.6%, despite the target of unchanged rates for the year. When the Fed reverses course, investors want to be in bonds.
This section examines the history of the Federal funds rate inflection points dating back to the last three recessions. Specifically, it points out how soon a recession occurred after a rate hike pause/lowering cycle, how far the Fed funds rate fell, and how it fared for bonds.
The 1980s was an incredibly volatile decade for interest rates as Volcker and Greenspan reacted to severe changes in the rate of inflation, ranging from 13.9% in 1980 to 1.1% in 1986. As the chart below demonstrates, the pre-1989 recession period does not follow the template of hike, plateau, and cut into a recession seen in 2000 and 2008. Before the Savings and Loan Crisis of the early 1990s, the Fed Funds rate peaked at 9.85 on March 1989. Ten months later, the economy was in recession and rates bottomed at 2.96 in 2003.
(Source: FRB of St. Louis)
Before the recession of early 2001, the Fed Fund rate peaked at 6.5 on June 2000 and remained at that level until cuts began in November of the same year. Six months later, the economy was in recession and rates were held near 1 through late 2004.
Lastly, rates peaked in July 2006 at 5.24 and remained at that general level for twelve months before cutting began. Six months after that, the economy was in recession and rates hit zero, not rising again until late 2015. The chart below shows the price of the US 10-year note since 2003. From that June 2007 inflection point when rate cuts began until mid-2016 when rates moved 30 bps, the 10-year gained roughly 30%.
If the global economy recovers from the rate hike pause/easing, bonds will rally in the interim until the Fed deems the environment safe to hike again. If the global economy does not recover and the next move in the funds' rate is meaningfully lower into a recession, expect a multi-year bond rally. In either scenario, I recommend purchasing bond ETFs to benefit from the macro situation.
Why this time is different and other asset classes to own
Value investors shudder at these words, but there's a statistical difference between this interest rate inflection point and the three previous moves. On average, the Federal Funds rate will fall 500 bps when reversing into a recession. Cuts in interest rates have the effect of pulling demand forward and encouraging consumers to borrow and spend. The Fed Funds rate currently rests at 2.4. Interest rates cannot move meaningfully lower in order to spurn the average demand necessary to lift the economy out of recession.
Furthermore, we now know that the capital injections provided through QE did not reflate the economy as well as expected. Instead, it primarily reflated asset prices. Even then, QE2 and QE3 reflated asset prices to a lesser extent than QE1. The first chart below shows the number of dollars necessary to create one dollar of wage growth, employment, corporate profits, and GDP. As you can see, corporate profits benefited tremendously while growth in the real economy lagged. Capital injections also faced diminishing returns. While QE1 had an effectiveness ratio of 1.6:1 (1.6% increase in the Fed balance sheet to create 1% increase in S&P 500), QE2 and 3 had a 1:1 effectiveness ratio. With QE already proven to disproportionately benefit the wealthy and rising global populist sentiment, one wonders if this policy tool will be as readily in the future.
(Source: Real Investment Advice)
With a diminished capacity to reduce rates and a lack of political will necessary to undergo a QE4 program at the scale necessary to make up for the weak rate cut, I believe the Fed and the Treasury will have to find other ways to reflate the economy.
Possible solutions include debt monetization or printing money to finance deficit spending, negative rates, and helicopter money in the form of universal basic income, which gives money directly to the consumer instead of indirectly by freeing up the lending complex. Debt monetization led to hyperinflation in 1920s Weimar Republic and universal basic income will likely be inflationary by increasing aggregate demand for goods. While QE only caused asset inflation, these alternatives will more than likely cause real inflation, lifting assets such as gold, commodities, and TIPS.
Using history as a guide, the Federal Funds rate will stay at 2.4 for the next several months, providing a buying opportunity for bonds. If economic conditions do not improve, rates will reverse to the downside. They may even reverse into a recession as the inverted yield curve in bonds suggests. If this occurs, a multi-year bond rally will ensue.
Additionally, with limited policy tools at the Fed's disposal, we will likely see creative methods of reflating the economy. Debt monetization and helicopter money are two examples of QE alternatives that are both inflationary. Therefore, be mindful of the policies implemented when rate cuts and QE are not sufficient, as these policies may be a boon for gold prices, commodities, and TIPS. I recommend being long bonds now and keeping a watchful eye on inflation hedges as events unfold.
Disclosure: I am/we are long TLT, SHY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.