A Looming Disconnect Between The Economy And Financial Markets

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by: Shareholders Unite
Summary

The Fed is mostly focused on conditions in the real economy, loosening policy when growth slows and tightening when the economy grows too hot.

It only takes on board financial market conditions when these become more extreme.

However, because changes in Fed policy have a much more immediate and dramatic influence on financial markets, the financial community parses every word of every Fed official.

This isn't a problem when financial markets and the economy are aligned. However, when they are not, this can become a serious problem for investors.

We often wondered how much of the financial community hangs on every word uttered by any Fed official and scrutinizes every word for any possible indication of potential policy changes. This seems odd to us because:

  • Given the dual mandate of the Fed, financial market conditions are secondary at best for the Fed itself. The Fed is concerned with the state of the real economy and takes the state of financial markets on board only in extreme cases.
  • The effect of monetary policy on the economy is much weaker than many seem to assume.

Much of the financial community is often highly critical of the Fed. For instance, the criticism of its December rate increase was often described in rather stark terms.

This is curious - anyone who seriously thinks that a quarter of a percent interest rate hike is going to tip over the economy? That is very unlikely given the fact that:

  • Interest rates are still very low, and real rates are barely positive, if at all.
  • Business investment is rather interest rate-insensitive. It's much more sensitive to changes in demand outlook rather than changes in rates.
  • The housing market is somewhat more sensitive to rates, but here the 10-year yield is much more important than the Fed Funds rate, and the 10-year yield has been going down quite a bit.

So, grosso modo, for the real economy quarter-point interest rate changes are really moot. Why is much of the financial community so focused on Fed policy changes?

Well, quarter-point rate changes might do little to the real economy, but one could argue that these signal a wider trend, in which case the effect on the economy becomes stronger.

But the December rate hike didn't fall under that heading. In fact, it was closer to the last hike in a trend rather than introducing any new tightening policy trend.

Financial markets

While its effect on the real economy is moot, monetary policy has a powerful effect on financial markets even if it doesn't signal a trend change.

This situation is somewhat curious, but the rationale here is that by decreasing or increasing rates, the Fed changes liquidity in the financial system as well as lowers rates on safe assets, which pushes people out (or into) more risky assets.

There is also something of a feedback mechanism to the real economy:

  • Insofar as increased liquidity pushes down rates across the spectrum, lower long yields have a mild stimulative effect on the real economy.
  • Financial market rallies produce a wealth effect, which could stimulate demand.
  • "Sentiment" could very well have real effects - a possibility most comprehensively argued by the economist Roger Farmer.

The contrast in effectiveness in monetary policy on the real and the financial markets was most marked in the years after the financial crisis. Monetary policy was really powerless in affecting the real economy.

Households were repairing the damage done to their balance sheets as a result of the housing bust, which wiped off $9 trillion of their balance sheet. Nearly double-digit unemployment didn't help either.

That is, even at zero interest rates, households were unwilling to borrow and spend, preferring to save and pay off debts. The post-2009 recovery is the first one in which households actually repaid debt rather than assumed new debt.

This repairing of balance sheets is one reason why the recession was so deep (another one was that this was also the first recovery in which the public sector employment went down rather than up).

So, monetary authorities had to resort to more forceful measures, and many embarked on quantitative easing - much to the consternation of many in the financial sector, where many warned of currency debasement and accelerating inflation, which of course never materialized, as monetary policy under these circumstances is pretty powerless to influence the real economy.

What it did though was pushing financial markets up, and while the post-2009 rally has had good support from an economic recovery and, hence, corporate earnings, the implications are starting to become more clear.

A weakening economy versus a loosening Fed

We are now in a rather prolonged economic upturn the longest in the post-war history. It has been given another boost by fiscal policy (both spending increases and a substantial tax cut).

But there are quite a few signs the economy is weakening, and internationally the situation looks more serious, with China absorbing the effects of a declining labor force, high debts and the US tariffs and the eurozone beset by its own contradictions where surplus countries are under no obligation to reflate, leaving all adjustment to deficit countries.

The Fed is aware of this and has signaled an easing of policy to come, probably as soon as next month. Predictably, this had a powerful effect on financial markets, with the June rally in particular being all about Fed easing:

Given the basic stylized facts developed above that monetary policy has a rather muted effect on the real economy but a powerful effect on financial markets, how should investors deal with this likely Fed policy change? That is, how long could markets continue to rally if the only fuel is the Fed policy change itself, with economic conditions worsening?

One could argue that this doesn't really matter all that much. If economic conditions keep on worsening, the Fed will keep on loosening monetary conditions, and will perhaps even restart asset purchases at some point. But this is on the assumption that the Fed is actually capable of reviving the economy - that really isn't a given. Real rates are already low, and looking abroad doesn't inspire a lot of confidence. Real rates are deeply negative in the eurozone, but this hasn't stopped the economy from sliding, for instance.

One could also argue that this might not even matter all that much, as low or even zero rates and plenty of liquidity push investors to more risky assets anyway, despite what happens in the real economy.

So, we could have a valuation multiple blowout, but here we are inclined to argue that these things have a habit of ending badly. Sooner or later this will catch up with the rally, as multiples can only be stretched so much, or one has to bank upon the economy recovering before that.

That is, in the end, it does matter what happens in the real economy.

Conclusion

Monetary policy has a much more powerful effect on financial markets than it does on the real economy, which explains why financial market participants parse every word of every Fed official searching for clues of coming policy changes.

While financial market participants interpret every possible policy change in terms of their impact on financial market conditions, this is unfair, as the Fed itself, given its dual mandate, has only passing interest in these, unless financial markets display such volatility as to threaten to spill over into the real economy.

This mismatch of objectives often leads to Fed criticism that is unwarranted, although often the objectives are aligned. That is, the Fed tends to ease when it sees a softening of economic conditions, and such outlook also typically softens financial market conditions. But given the much more powerful effect of Fed policy on financial markets compared to the impact on the real economy, a dangerous mismatch might occur between the two.

It looks like we are facing such a mismatch possibility, with financial markets rejoicing expected Fed softening of policy, but with the distinct possibility that the softening of policy will do little to stem, let alone reverse, the tide of softening economic conditions.

If that's a correct assessment, then sooner or later this mismatch will correct, and either the economy will turn up again or stocks will come down.

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.