Is the Fed causing the recent stock market ruckus? "Probably"

As we bring the 3rd quarter to a close, we also come to the end of a very volatile season for markets.  If you were to look back over the past several weeks, we wouldn’t be surprised if you asked the question, “What in the world is going on with the markets?”  And by “markets” we are referring to the US and International markets covering stocks, bonds and other words, the whole enchilada.  From the last part of September through the early days of October, markets across the board moved lower.  So, what is causing this market action?  Is it China, tariffs or energy concerns dragging markets lower?  Or is it something a little closer to home?   Using our best Hans Gruber voice, the villain character from the Bruce Willis Christmas classic film Die Hard, “… I give you the F-E-D,” spoken very slowly for dramatic effect.  In the movie, of course, he was talking about the FBI.

So, what has the Federal Reserve (the “Fed”) been up to in order to cause such a ruckus?  During its most recent September FOMC meeting, the Federal Reserve voted unanimously to move short-term interest rates higher to 2.25%, which was expected.  While this is only their 3rd move of the year, it looks like the Fed has already penciled in another 0.25% increase in December, which would make 9 hikes since December of 2015.  And more could be in store as the Fed, led by Chairman Jerome “Jay” Powell, continues to search for the “neutral rate”.  (More on “neutral rate” in a minute.)  Why would markets react so negatively to something the Fed said it was going to do and which market participants expected it to do?  We believe the root of the downward market swing has to do with interest rate inversion and recessions fears.

Normally, short-term interest rates are lower than long-term rates.  That is because inflation and uncertainty are more likely to have an impact over the long-term than over the next 1 or 2 years.  So then a line draw between the level of short-term rates and that of long-term rates is a rising line or curve (ie. the yield curve).  In the summer of 2016, rates on 2-year Treasury bonds were 0.6% and rates on 10-year Treasury bonds were around 1.5%.  The yield curve between the two rates rose 0.9%.  Since then, the interest rate on 2-year bond has risen about 2.3%, while the rate on the 10-year has risen 1.7%.  Now the same yield curve rises only 0.3%, which is beginning to look flat.  If long- term rates fall below the Fed’s short-term rate, the yield curve is “inverted”, meaning it slopes downward.  This is important because the past eight recessions have been preceded by an inverted curve, and as we know, investors pay attention to these sorts of things.  So, market participants are asking the question, does the Fed really need to keep raising rates and risk a recessionary indicator?

When asked about the fear of an inverted curve causing a recession Chair Powell responded that there is no evidence that an inverted curve was a predictor of a recession and that he and the rest of the Federal Reserve members thought it was more of a coincidence than a cause.  According to Chair Powell, these rate hikes are more about finding a “neutral rate”.  Neutral rates are defined as interest rates that neither help or hinder the economy.  Determining neutral rates for the economy is no easy task.  Even for the Fed, this would appear to be more of a guessing game than anything.  Here is an excerpt from a recent PBS interview with the Fed Chair.  "Interest rates are still accommodative [ie. supporting the economy], but we're gradually moving to a place where [their impact] will be neutral.  …  We may go past neutral, but we're a long way from neutral at this point, probably."  “Probably” is not the kind of word you want to build your long-term plan on.  If Fed committee members continue to make comments like that, then broad equity markets are “probably” going to experience additional volatility. 

Could it be “probable” that the Fed is simply increasing rates now when they are fairly certain that the financial markets can handle the interest rate increase?  These types of moves would give the Fed some needed monetary ammunition during the next economic downturn, whenever that may occur.  Currently, market and economic conditions are far from showing any signs of a recession.  But it is certainly “probable” that one may happen, one day.

One thing we do know for certain is that we wanted to welcome our newest team member, Joseph Davis. Joseph who is a Knoxville resident, will be spending most of his time working in the Knoxville market and will be assisting David and Erik with research and trading responsibilities going forward.  Joseph has a varied background that spans from music DJ to options investing.  And in that respect, Joseph is in good company as the current CEO of Goldman Sachs, David Solomon, is also a part time DJ!  Joseph is a graduate of University of Tennessee with a BA in journalism and has spent the last several years working on several volatility and momentum trading strategies.  It was his work in volatility at Davis Investing that actually brought us together.  We are glad to have Joseph as part of the team.

Don’t forget the November 8th town hall discussion at Feed, located off of Main Street on the South Side.  See you there.