An Urban's Rural View
Whither Interest Rates as the Stock Market Duels the Fed
On most days, despite the best efforts of the financial journalists who write the stock-market stories, it's impossible to know why thousands of individuals decided to buy or sell.
Every now and then, though, the reason is perfectly clear. A recent example: the wild collapse of stock prices during Federal Reserve Chairman Jerome Powell's press conference after the Fed's latest interest-rate hike. As Powell was outlining the Fed's plans for next year, the market tumbled more than 500 points. The extent of the Fed's responsibility for the continuing stock-market carnage before and since has been exaggerated -- there are a lot of other factors, the trade war not the least. But during the press conference no one doubted that the market's nose-dive was a reaction to Powell and the Fed.
There's no question that the Fed's interest-rate hikes are unpopular. They always are. This time around, according to the talking heads on CNBC, not to mention the president, the Fed is making terrible mistakes. First, the central bank raises rates at a time when equity traders are pessimistic about the economic outlook. Then it compounds the problem by indicating it might continue next year to raise rates. Why do this, the talking heads demand, when the economic outlook is so uncertain and inflation so tame?
The talking heads and the equity traders could be right; the market often sniffs out economic problems before economists, even the Fed's talented economists. On the other hand, the economy is currently growing at 3.5%, the unemployment rate is 3.7%, holiday retail sales are strong and the Federal Funds rate, adjusted for inflation, is near zero. So while the Fed may be wrong, it isn't exactly crazy to think that its current policy is stimulating an economy that doesn't need stimulus.
Then, too, the market isn't hearing what the Fed is saying. It hears, "We're going to raise rates two more times next year." But that "two" wasn't a statement of intent; it was more like a forecast, one that could change as conditions change. The market refuses to hear the Fed's assurances that it isn't locked into anything; that it will keep reviewing the data and be prepared to alter course; that it will be "data dependent."
This deaf-ear treatment is interesting, because, effectively, the Fed is saying to the market, "If you're right and the economy goes the way you think it's going to go, we'll be suspending the rate increases. If we continue them, it will be because your current pessimism is misplaced and the economy is doing fine, in which case you will have regained your optimism." In other words, the market can't lose.
This seems so obvious that I have to think the market's problem is deeper than the prospect of two more quarter-point interest rate increases -- increases, incidentally, that would only raise the Federal Funds rate to a still historically low 3% or so.
The real problem is the Fed's determination to get its balance sheet back to normal and unwind "quantitative easing." In the years following the 2008 financial crash, when the government was running big deficits and thus had big borrowing needs, the Fed was buying large quantities of the government's debt.
It was an additional way to support the economy. The built-in demand for Treasuries helped keep interest rates low, leaving bonds yielding relatively little and stocks thus looking that much more rewarding. Through this quantitative easing, the Fed piled up $4.5 trillion of debt paper on its balance sheet.
In recent years, as the economy has improved, the Fed has stopped the big buying and is letting paper expire off its books as it comes due. At his press conference, Powell made clear the Fed intends to continue this unwinding. The economy, in the Fed's view, is returning to normal and thus it's wise to return to normal monetary policy.
Sooner or later, there had to be a return to normal monetary policy. For the market, this isn't an ideal time for it. That's because the government hasn't cut back on its borrowing; it continues to run bigger and bigger deficits. Next year it will have to issue a ton of debt paper and the Fed won't be sopping up the excess supply. When that happens, the market expects interest rates on Treasuries to go up and stocks to become less attractive. Couple that with what it sees as a weakening economy and you can understand the market's temper tantrum.
A few days after Powell spoke, another senior Fed official, John Williams, said that even this balance-sheet normalization could be put on hold if the economy head south. Continuing that policy is also, Williams indicated, data-dependent.
We may never know if the market will hear and take seriously what Williams is saying. For if the economic outlook is really as gloomy as the market thinks, even a Fed stand down might not be enough to restore the market's bullishness.
Where does this leave farmers and ranchers? They like a strong economy but they definitely don't like higher interest rates. Their assets are mostly tied up in land and equipment, not equities, so they don't feel the pain of a bear market the way other business borrowers do. On balance, they probably would like the Fed to stop raising rates.
In the long run, everyone needs to understand that massive government deficits will increasingly limit the Fed's ability to control interest rates. If Uncle Sam continues to need to borrow close to a trillion dollars a year, interest rates will go up regardless of what the Fed does. What drives markets day-to-day may be opaque, but that they're ultimately ruled by supply and demand is abundantly clear.
Urban Lehner can be reached at email@example.com
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