Federal Reserve Watch: Markets See Data Driven Fed Lowering Rates

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by: John M. Mason
Summary

Fed Chair Jerome Powell and other members of the Fed's Board of Governors have been giving signals that they are considering lowering the Fed's policy rate of interest.

The reason for this talk is that the economic data they are receiving point to a slowing of economic growth and continued modest inflation.

Thus, these officials can build a case for dropping rates that has nothing to do with politics, but that can continue to support the confidence of investors and financial markets.

For several years now, officials at the Federal Reserve claim that they are data driven.

Well, the markets continue to take the Fed at its word.

After favorable words by Fed Chairman Jerome Powell and other Federal Reserve officials this week, the stock market has took off, bond prices rose, and the value of the US dollar declined.

The stock market rose due to hints that Federal Reserve officials might lower the policy rate of interest this year, once, if not twice. This move just confirms the relationship built up over the past ten years or so between the stock market and a supportive Federal Reserve.

Bond market prices rose because the statements from Chairman Powell and others signaled to investors that the data being received by the Fed indicated a slowing down of the economy and continued modest price increases.

The value of the US dollar declined because the expectation of lower interest rates causes the dollar to drop relative to currencies of other nations that are not expected to drop their policy rates of interest.

On Friday, news from the labor market appeared to support these feelings.

Only 75,000 jobs were added to the economy in May, one of the lowest totals since the end of the Great Recession. Economists took this low number as another indication that the US economy seemed to be slowing.

“The Dow Jones Industrial Average extended its rally Friday, putting the index on pace for its best week in more than six months, after lackluster employment figures for May fanned investors’ expectations of loosened monetary policy.”

Thus, with the data moving this way, officials at the Federal Reserve can feel justified in leaning toward lowering the Fed’s policy rate of interest because of the changing economic conditions. Many Fed officials, especially Chairman Powell, seemed to be uncomfortable talking about lowering the rate if it appeared as if President Trump was bullying them into such a move.

The target range for the Federal Funds rate is now 2.25 percent to 2.50 percent, and the effective Federal Funds rate has varied between 2.37 percent and 2.45 percent ever since the Fed changed the range in the middle of December 2018.

At the same time, the yield on the 3-month Treasury bill is just under 2.30 percent. For much of this year, this yield has varied between 2.35 percent and 2.45 percent. Thus, from late December 2019, the 3-month yield has been close to or above the yield on the 5-year US Treasury note, and since early May, this has placed it near the yield on the 10-year Treasury note. The flat or inverted yield curve.

One can argue, however, that the inversion of the yield curve has come from the decline in the longer-term end of the bond market. Whereas the 3-month rate rose with the increase of the Fed’s policy rate of interest in the November/December time period, the yield on the 10-year Treasury note has fallen dramatically since that time.

Just before the Fed raised the policy rate in December 2018, the 10-year Treasury yield was up in the 2.80 percent to 2.90 percent range. The decline in this longer-term security came through a fall in the yield on the Treasury Inflation Protected securities ((OTC:TIPS)) while inflationary expectations remained roughly the same.

Note, the yield on the 10-year TIPs dropped by over 70 basis points from about 110 basis points in the middle of December 2018, to just under 40 basis points in recent trading.

Two things, in particular, have changed. First, investors grew more and more concerned over the strength of economic growth. Throughout the past six months or so, markets have reflected a decline in optimism about economic growth, both in the United States…and in Europe…and in the world.

Secondly, there has been a major change in the trade talks that have been going on in the world, followed by the threat by President Trump about raising tariffs on Mexican-produced goods.

These events have changed the whole psychology of the market place and have created an ever increasing problem for the Fed. This has raised another question to me, “Can the Fed Stay in Control?.”

To me, this is a very precarious time for the Fed. I believe that the Federal Reserve has done a very good job in getting us where we are today. But, market conditions and political conditions are creating lots and lots of uncertainty, an uncertainty that Fed officials have to deal with in setting monetary policy.

Right now, Chairman Powell and other Fed officials are using verbal guidance to guide the markets. This, as described above, has buoyed the financial markets…at, least for the near term.

But, 2019 is not going to be an easy time, given all that is taking place and given all that could take place. We have the known unknowns to thing about but then there are the unknown unknowns. How will the Fed handle them? And, how will markets react?

Federal Reserve officials still are pursuing the goal of reducing the Fed’s securities portfolio. So far this quarter, from March 27 through June 4, the securities portfolio has decline by more than $106 billion. This pace is still in keeping with the original Fed targets of, at this time, removing about $50 billion in securities each month.

Overall, since this “reduction” operation started, the Fed has overseen a decline of just over $600 billion in the securities portfolio.

Reserve balances at Federal Reserve banks, a proxy for “excess reserves” has declined by almost $620 since the program started.

The crucial thing to remember about this effort is that the Fed has always stated that it would err on the side of not reducing the portfolio too fact, because it did not want to create any liquidity problems for the banking system.

In my research, I have seen no indication that the reduction achieved by the Fed has caused any liquidity problems in the banking system. The banking system seems to have a very adequate amount of liquidity.

And, so the adventures of the Fed continue. Their actions still need to be closely watched.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.