Broker Check

The markets lead and the Federal Reserve follows

November 05, 2019

November 2019

The Federal Reserve said they would raise rates 3 times in 2019, but instead have cut rates 3 times so far and perhaps with more cuts to come…

The Federal Reserve simply is behind the curve because they are only using historical data to determine their interest rate policies that will impact the future.  This is like driving a car while looking in the rearview mirror.  Worse yet, they lack the foresight to connect the dots to take proactive actions.  Wayne Gretzky, the hockey Hall of Fame player, once said: “I skate to where the puck is going to be, not to where it has been”.  

The Federal Reserve skated right to where the puck was and missed it, when they raised rates 4 times in 2018 and stated 3 more hikes were to come in 2019, over-reacting to the tax cuts announced in late 2017, which led to above trend economic growth.  All thru 2018 as they raised rates, they failed miserably to comprehend the damaging impact of their hikes and the trade war would have on business sentiment and ultimately on business spending!  Although, they readily admitted last year that they were aware of business CEOs’ concerns about the trade war, they said: “we haven’t seen it in the numbers yet” and kept on raising rates. 

In late summer of 2018, both the bond and stock markets “skated to where the puck was going…”

The markets are forward looking, investors connected the dots and recognized the risks from the trade war and the wrong Federal Reserve policy; causing long term interest rates and the stock market to drop sharply. This market action culminating with a tumultuous last week of 2018.  While, the risks were real, the extent of the market declines were outsized relative to the risk, as the tighter monetary policy and the trade war just negated the tax cut of 2018; economic growth just would have dropped back to trend line.  Sentiment, however, was extremely pessimistic as investors were very frustrated about the clueless Federal Reserve and the escalating trade war combatants. 

The Federal Reserve and trade war combatants blinked as the markets railed against them…

The market vigilantes spoke loudly and forced better policies.  The Federal Reserve stopped raising rates in early 2019 and began cutting rates starting in late July 2019; US and China are now in a cease fire/de-escalation phase. 

Where did the puck go?...  

From the chart below, you can see that corporate CEOs, like lenders/investors, also became pessimistic.  While consumer spending was strong, they didn’t raise business spending accordingly; instead, they used their profits to repurchase their stocks and raise dividends given the increased uncertainty.  Ultimately, in the second quarter of 2019, business investment contracted, which gave the laggard Federal Reserve the “data point” they needed to cut rates!   

Where will the stock market go?...

With the stock market in control and mandating better policies from the Federal Reserve and the trade war combatants, I am cautiously optimistic about the stock market. The pause in the trade war escalation is a positive but not ideal as there is no trade deal.  Ultimately, I don’t believe, a trade deal can be consummated in the near term as the issues are too broad/complex and the two sides do not have enough common ground.  A stealth trade war will continue until the participants are changed, one way or another. 

I expect the market to go to new highs, but volatility will remain as that is the “stick” the investors will continue to use to force good behavior from policy makers.  In this environment, managing risk/reward is paramount.