Zeller Kern’s Investment Monitor

Are We Heading Back to 0% Interest Rates?

March 27, 2019

By Steve Zeller                           

The market roared back from its “Christmas massacre” corrective low in December, but now it could be telling us that “this is all she wrote.” A lot of significant developments within the economy have recently taken place that are suggesting further weakening. But economic trends are actually unfolding exactly how our firm expected they would, based on the data we have been tracking for several months.

Our readers and clients may recall that our stance, towards the beginning of Q4 of last year, was that we had entered a period of slowing growth (meaning slowing GDP), slowing corporate earnings, and a slowing of inflation. That indeed did happen, as the growth rate of earnings came way down from its rate of growth from earlier 2018, the GDP rate growth has slowed down substantially, and inflation began to slow. What typically happens, after that has been realized, is the Fed steps in and does an about face on their policy, or at a minimum, reassures stock market investors that the hikes are over – creating a temporary euphoria and celebration, sending market indices upwards.

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That indeed took place, and Fed Chairman Powell, came out of last week’s FOMC meeting and announced that the Fed was done raising rates for the rest of the year. In fact, what we are confident in saying is that the Fed will likely find itself lowering rates in the near future, perhaps by the 3rd or 4th quarter of this year. Keep in mind, the global economy has been slowing significantly, and U.S. corporate earnings are under significant pressure for two main reasons. One, revenues appear to be declining, along with labor costs rising – That is bad for stock valuations and stock prices. Two, when the Q1 earning season begins in another month or so, those earnings will be compared against Q1 2018 numbers, which were more robust than Q4 of 2017. That increases the likelihood that we may be in an earnings recession beginning in Q1 of this year.

GDP estimates, as per the Atlanta Fed GDP Now forecast is currently trending at 1.5% for the first quarter, down significantly from Q3 and Q4 of last year. Even though it is up from the previous trend estimate of .4%, it is still trending down, notably. The number was revised upward after “Existing Home Sales” came in better than expected. According to the Wall Street Journal, existing home sales rose 11.8% in February from the prior month, the second highest monthly gain on record. But sales volume was 1.8% below where it was one year ago.

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In the meantime, the bond market has just priced in a coming recession by sending the yield on the 10 Year Treasury Bond down to the 2.445% level as of the close on last Friday, and has proven to be a good place to be invested for the last several months.

The U.S. 10 Year Treasury Yield – 1 Year

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December’s rate hike by the Fed, ended their efforts in historic fashion, with the Fed actually hiking rates into a slow-down, putting them behind the curve. So, after the announcement on last Tuesday ending rate hikes for the rest of the year, stock investors couldn’t buy enough. But this typically is short lived; now the yield curve for treasuries has gone into an inverted condition, where short term rates are now higher than longer term rates.  When this happens, the stock market typically falls into a state of reckoning, which might have started at the end of last week. As far as whether a long-term top is in for the market, remains to be seen. An interesting pattern that has formed, is what technical analysts call a “head and shoulders” pattern, which is arguably a sign of a market top.

S&P 500 Chart – 1/1/2018 – 3/24/2019

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So, what if we continue to slow economically? What will the Fed do? One place of reference to help answer the question is to read the Fed minutes from the FOMC on August 1st of last year. There are notes on how they would fight the next recession – Their solution will be to take short term rates down to zero. But, if you look at things historically, not only will the Fed take rates down to zero, but would arguably send rates into a negative interest rate environment, which would create a negative savings rate for bank savings accounts. That is currently the case for many depositors in areas of Europe.

To help prove my point, when there is a recession of a significant magnitude, the Fed typically lowers rates by at least 5%. As David Rosenberg recently stated on a Macrovoice Podcast, The Fed, in the late 1980’s brought the Fed funds rate from 9 7/8% down to 3%. During the Dot.com bubble in 2000/2002 period, the Fed brought rates from 6.5% down to 1%. And in the 2006 – 2007 time frame, the Fed brought rates from 5.25% down to 0%!

This time around, things are different. Even after a series of rate hikes, the Fed is starting out at 2.5%. That would require them to go far lower than 0%, if they were to stick to a 5% reduction strategy. Additionally, the Fed is currently sitting on approximately $3.9 trillion in assets on its balance sheet. That gives them relatively little wiggle room to drive down interest rates by instituting further asset purchases, relative to where they were in 2008.

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Furthermore, the political environment is changing too, as a result of the last series of QE (Quantitative Easing). The first QE that took place in 2008, was an effort to prevent the financial system from imploding due to the mortgage meltdown. Most would go along with that as being justified. However, the following QEs were done for the purpose of reflating stock market indexes and stimulating spending through wealth creation. The Feds and the other major central banks around the world certainly reflated stock prices and created wealth, but the spending never really followed. Additionally, by cheapening currencies, it crushed the working class and created a huge inequality in wealth.

Fast forward to the present time, and you have this issue becoming a political movement known as “Modern Monetary Theory”, promoted by certain political circles. Modern Monetary Theory”, or MMT, suggests that printing unlimited money and distributing it to citizens, instead of the banks. Also, debt is not an issue because you would simply monetize it. It is unimaginable what the results would be, but the Fed has suggested that they might have to resort to the monetization of debt if they had to.

Regardless of how and if this plays out in our future, it is pretty apparent that the “laws of diminishing returns” is certainly a reality when it comes to the progression of Fed stimulus. At the same time, the Fed has clearly indicated, that if they need to, they will get very aggressive.

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Classic cartoon of Fed Chairman Ben Bernanke’s strategy of massively printing money “Helicopter Ben”

In the meantime, we’ll see how things play out with the equity markets. It is still uncertain if the Fed can convince investors that it will help the market continue to appreciate in value, and whether investors remained convinced that the economy will remain in a positive growth trend in the second half of the year.

There are a couple of reports coming out this week that will give us further indication. On Monday, the Dallas Fed Manufacturing Survey will be released. On Tuesday, the Richmond Fed Manufacturing Index release is expected to show a reading of 11. On Thursday, Kansas City Fed Manufacturing will be released and Chicago PMI on Friday.

These reports will be watched very carefully to see if continued weakness is showing up. Regardless, while there may be a slowdown, we are long ways from a recession.

The big report that will be released on Thursday will be the GDP which is expected to come in at 2.2%. This estimate reflects downward revisions to a range of components, especially service spending. Also, the consensus for the final fourth-quarter GDP is for a +2.2% compared to +2.6% in the prior estimate. This report will be important and will affect market sentiment.

Looking Back At Last Week

The S&P declined by 0.8% last week in a tale of two narratives. The first narrative triggered the S&P to rally to a new 2019 high on a notion that low U.S. Treasury yields with a dovish Fed were a boon for risk assets.

However, this all came to an end on Friday with the combination of treasury yields declining, recession fears due to the manufacturing release, and the potential impact of the Mueller report. The Dow Jones declined 1.3%, the NASDAQ composite lost 0.6, and the Russell 2000 declined sharply finishing lower by 3.1%.

The financial sector took the biggest hit showing a 4.9% decline, pressured by the concerns that the compression and spreads would lead to week interest margin for lenders. While, the consumer discretionary (+1.2%), real estate (+0.9%), and consumer staples (+0.7%) as these sectors outperformed.

On Wednesday, the Federal Open Market Committee left the target range for the Fed Funds Rate unchanged at 2.25-2.50%. They also signaled that it does not expect any rate hikes now in 2019 versus two rate hikes expected at the time of the December 2018 meeting; and said it would begin tapering its balance sheet runoff in May with an end date of Sept. 30.

The Fed's pivot to an even more dovish mindset made it clear that the market doesn't have to fear the Fed like it did in the fourth quarter. However, most viewed the pivot by the Fed as a negative for economic growth.

Growth concerns were reinforced by earnings warning from FedEx, disappointing manufacturing data out of Europe, and declining exports out of Japan and South Korea. FedEx called attention to slowing international macroeconomic conditions and weaker global trade growth trends.

Friday’s action was a massive reversal from Thursday’s upward move and the new high close for 2019. While the 1.9% decline felt catastrophic from a technical viewpoint, it was not. The action has triggered the market into a sideways trading range which is likely to decline toward the 2776/2761 levels. While the short term momentum dissipated substantially, there is still an underlying trend that is dominating the intermediate and long-term patterns.

The critical level on the downside today is 2791.20. A penetration indicates a further decline toward 2780/2770. On the upside, the pivot level is 2810.15. A penetration would suggest a move toward 2820/2830.

Best Wishes,

Zeller Kern Investment Committee