Take Notice of the Fed’s Big Red Flag

By Lance Gaitan

Every six weeks the Federal Open Market Committee (FOMC) meets to decide whether a change in policy is needed to coax our economy in the right direction. They wrapped up their latest meeting on Wednesday. When Fed Chair Jerome Powell delivered his policy statement, stocks bounced and Treasury yields fell sharply.

(Keep in mind the Fed has a Congressional mandate to provide maximum employment and stable prices. It accomplishes this goal primarily by manipulating interest rates.)

According to Powell, interest rates aren’t helping or hindering economic growth. The jobs market is strong, and inflation is near the Fed’s 2% target. Everything seems just about right. So, the Fed is now looking for signs of a slowdown, even though they aren’t expecting one.

What caught investors’ attention was the Fed’s change in projections. Back in December, the Fed expected to hike twice: one in 2019 and another in 2020. But now the Fed isn’t projecting any rate hikes in 2019.

Why the Change of Heart?

Worry over the prospects of our economy.

All evidence indicates that a slowdown is indeed ahead. Housing is worrisome, consumer spending is falling, and inflation isn’t rising as planned. The Fed may have gone too far already in hiking rates and reducing the balance sheet, even if Powell seems reassured.

The Fed decided to leave the federal funds rate (the overnight interest rate it charges borrowing member banks) unchanged at the 2.25%-2.50% range for now. An increase to the rate means that the economy is growing too quickly, or inflation is moving too high. A cut to the rate suggests a sluggish economy or falling prices.

“Normalize” the Balance Sheet

The balance sheet before October 2017 stood just above $4.5 trillion, and held a mix of mortgage-backed and Treasury securities. Since then, the Fed has been shedding $30 billion per month of maturing bonds by not reinvesting. When May comes around, the Fed will reduce that $30 billion to $15 billion per month, leading to the end of “normalization” in September with a little over $3.5 trillion in Treasury securities.

I’m not sure how the Fed declares $3.5 trillion as “normalized” when it was less than $1 trillion before the 2008 financial crisis… but, according to Mr. Powell, it is.

At least the markets know the end is in sight for this “normalization.”

Meanwhile, judging by futures trading, the Treasury bond market is pricing for a rate cut for later this year in anticipation of the economy taking a turn for the worse…

Hard Times on the Way

The economy’s broadest measure is gross domestic production (GDP). The Fed predicts it will now only grow 2.1% this year as opposed to the 2.3% they projected last December. And the GDP is expected to drop to 1.9% in 2020 – down from the projected 2%.

Though still historically low, unemployment will take its licks in the coming years. As of the latest update, it currently sits at 3.7%. And it’s projected to be 3.8% in 2020 and 3.9% in 2021.

Here’s the thing… the Fed originally projected the federal fund rate to be 2.9% in 2019, but now the estimate stands at 2.4%. So, the Fed doesn’t expect a hike the rest of the year. In 2020 and 2021, the Fed expects the rate to climb to 2.6%. That change in the projected rate is the big market mover. No other data will affect the markets quite like this.

Don’t get me wrong… the Fed always adjusts its projections. In this case, they’ve implied that rate hikes in the near future are on hold because the economy looks to have slowed too much. That was a complete flip to what was said before, and it’s a big red flag!

Markets Are Getting Ready

If long-term Treasury yields remain low, and the spread between short- and long-term Treasurys continue to narrow – with yield curves flattening – the markets are positioning for a worsening economy.

And if – and this is a big if– the economy plugs away around a 2% growth rate… and the jobs market doesn’t collapse… and inflation remains near the Feds target 2% rate… don’t expect any change in policy.

Mr. Powell did note slower growth in consumer spending and muted inflation, as well as a slowdown in jobs growth. But with wages on the rise, there’s little concern. Powell’s also monitoring the risks associated with global trade negotiations and the Brexit uncertainty since the U.S. will feel any global slowdown.

China’s economy has slowed, but Powell expects it to stabilize, and he isn’t concerned about Europe’s slowdown leading to a recession.

What Does This Mean for You?

The Fed has reversed its path on interest rates hikes and its outlook for the economy. You need to take notice. The Feds projections for the next few years seems to be steady as she goes, but my advice is to be on your toes…

Don’t get fooled by the Fed’s apparent complacency. The economy, the markets, inflation – just about everything – is in flux.

We are likely moving into a period of higher volatility. And that means greater opportunities to profit!

Lance

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