There is No 'Neutral' Monetary Policy Anymore; That's a Problem for the Fed
There are a lot of reasons the S&P 500 hit record high levels yesterday. The most obvious is that the U.S. economy is strong. Unemployment is at record lows and growth, while not spectacular, is solid and better than in most other developed nations. Some would argue, though, that the biggest influence of all on stock prices has been and will continue to be the actions of the Fed. That is why, even as earnings come thick and fast, investors should stay focused on the Fed, and watch the actions and comments that come when their monthly meeting ends tomorrow very closely.
The collapse in stocks at the end of last year came not because of any real change in economic conditions, but because it was feared that the central bank was set on 'normalizing' interest rates by continuing to hike, albeit slowly. With the rest of the world slowing down, and the trade war worsening at that time, there was a serious risk that further rate increases this year would derail the nearly decade-long recovery.
The FOMC obviously shared those fears, as they reversed course and started to cut rates instead.
The theory behind rate cuts being stimulative is that lower interest encourages borrowing, resulting in greater business investment and consumer spending, both of which drive growth. These days, that theory doesn’t seem to be working, but when it comes to the market’s direction, that doesn’t matter. Rates are still the major driver of stocks.
When you start from rates that are, from an historical perspective very low, and have been for some time, further cuts have very little stimulative impact. For corporations, the difference between borrowing at 3.0% and 2.75% is not enough to prompt a decision, and after years of low borrowing costs, most of those that want to invest already have.
However, despite that, even a small cut in already low rates can still drive the stock market higher. What it does is to force money into equities. Global capital is constantly seeking a return, and the desirability of assets is mostly relative. Even if stock valuations look high, if returns on treasuries and corporate bonds are falling and are expected to continue to drop, the big funds will buy stocks.
The flip side to that is that if that expectation changes, valuation begins to matter again regardless of economic conditions.
The problem that the Fed faces as they meet this week then is an unenviable one. Cutting rates further from this point will probably have little effect on the real economy but will leave them with very little room to move if some unexpected turn of events causes conditions to worsen. On the other hand, the stock market is working on the assumption that there are more cuts to come.
If we look at bond futures, the market seems to be pricing in a cut this month but is now indicating that further cuts are unlikely to come soon. If that is what Jay Powell says, or even hints at after this meeting, he will no doubt present it as a pause in the current policy, and a move to a 'neutral' monetary policy stance. The problem is that there is no 'neutral' anymore.
If there is a clear indication that this run of interest rate cuts is over, there will probably be a severe reaction in the stock market. If they cut and Powell hints that there are more cuts to come then, as happened at the start of this year, the market will soar, leaving the old highs way behind.
Over the next couple of days, we could be looking at a situation where the Fed cuts rates and earnings continue to exceed expectations, but stocks turn downwards in a big way. Or, we could see risks and multiples being ignored again, and stock rocketing higher. There is no neutral policy stance anymore, so there is little chance of a neutral reaction from traders to whatever the Fed announces. So, even as earnings flood in, data are released and the political crisis deepens, keep your focus on the Fed.