As U.S. Federal Reserve chair Jerome Powell last Wednesday described why the central bank’s interest-rate cut should not be seen as the start of a lengthy easing cycle, the U.S. stock market was losing value at a rate of more than US$25-billion a minute.
At issue was one of Wall Street’s oldest play books: “Don’t fight the Fed.” Investors have long taken cues to buy or sell equities from the Fed’s decisions to revive or cool the economy by adjusting short-term interest rates.
Yet for the first time since the financial crisis, voting members of the U.S. central bank appear to be at odds over their interpretation of financial data and the Fed’s responsibility to act, leaving investors guessing as to what the Fed is basing future rate decisions on.
President Donald Trump, who has been lambasting Mr. Powell about not lowering interest rates fast enough, unexpectedly announced an additional 10-per-cent tariff on Chinese goods Thursday, possibly putting additional pressure on the Fed to cut rates aggressively.
Mr. Powell has repeatedly said the central bank makes decisions independently from markets and the White House. On Wednesday, he described the widely telegraphed 25-basis-point rate cut as a “midcycle adjustment” in response to signs of a global slowdown, simmering U.S. trade tensions and a desire to boost too-low inflation, before leaving the door open to additional cuts depending on future economic data.
During those 18 minutes of confusion, the benchmark S&P 500 plunged 1.75 per cent, representing a market value loss of US$461.7-billion, according to Refinitiv data.
Two Fed members dissented from the Fed’s rate cut, the first time since at least 1998 the initial vote to lower rates in a cycle was not unanimous. With the Fed split at a time of decades-low unemployment and other signs the U.S. economy continues to expand, equity and fixed-income fund managers say they are left with few clues to gauge the next move from the world’s most powerful central bank.
“We’ve been trying to come up with historical analogies and we just can’t find one. This makes this market very unique and it’s one of the reasons why you had the muddled if not messy reaction to the Fed decision,” said Brian Jacobsen, senior investment strategist at Wells Fargo Asset Management.
As a result, Mr. Jacobsen said he is focusing on higher-quality equities and corporate bonds, rather than the companies with weaker balance sheets that would typically benefit the most from a reduction in interest rates.
BULLYING THE FED?
It was not Mr. Powell’s first run-in with markets.
In December, Mr. Powell effectively reiterated past Fed guidance when he said the Fed’s plan to trim bond holdings was on “autopilot.” Still, stocks sank on disappointment he did not indicate more flexibility.
Markets were also confused by remarks Mr. Powell made in October describing rates as being a “long way” from neutral levels that neither stimulate nor brake the economy, suggesting the possibility more rate hikes might have been warranted. Fed officials ended up clarifying that rates were nearing estimates of a neutral level.
The New York Fed polls big investment firms on how well they are communicating. In the most recent survey taken in early June, just 38 per cent of respondents rated the Fed’s communications with markets and the public as effective.
The market is now pricing in a 61.2-per-cent chance the Federal Reserve cuts interest rates at its September meeting, and a greater than 70-per-cent chance of a cut in either October or December, according to CME Group.
Those high expectations of future rate cuts at a time when the Fed is not clear as to its path could lead to a decline of 10 per cent or more in the S&P 500 in the next few months if the market is disappointed, said Phil Orlando, chief equity strategist at Federated Investors in New York.
As a result, he has been reducing his overweight to U.S. stocks and other risky assets in the short-term, though he says he expects the Fed will bend to the market’s wishes rather than the market taking its cues from the central bank.
At the same time, Mr. Trump has been unusually outspoken in his criticism of the Fed and his desire for several interest-rate cuts.
“In our view, on the basis of data alone, the Fed would have done nothing,” Mr. Orlando said. “But the question I can’t answer is how much did the market and the President get in their heads and force them to change the course of policy?”
Terri Spath, chief investment officer at Sierra Investment Management, said Mr. Powell’s poor job of defending the Fed’s decision in his news conference Wednesday contributed to the “complete state of confusion” among investors.
“He did what was expected, but the market was looking for more to go on,” she said. “I’m firmly in the camp that the Fed didn’t need to cut, and this contributes to the sense that there’s an unease over the gains we’ve earned this year” in the stock market, she said.
The benchmark S&P 500 Index is up more than 20 per cent for the year to date, largely owing to expectations of a series of equity-friendly interest-rate cuts this year.
Even if the economic data do not suggest the need for more rate cuts, the potential power of the markets to prod the Fed into continuing on a stimulative easing path makes it more difficult for active managers to invest on a fundamental basis, said Eddy Vataru, a portfolio manager at Osterweis Capital Management.
“Now we’re in a funny position that we are analyzing trade news and [European Central Bank] policy even more than we might have a month or two ago because we have to think about what the Fed thinks the markets expect from it,” he said. “The market is getting its way and imposing its will.”