I must say, it is hard to keep the faith when U.S. Treasury yields plummet and our Bloomberg and business news television screens are teeming with investors and analysts howling about recession and the urgent need for the Federal Reserve (Fed) to cut rates. We have been in the camp placing a low probability of U.S. recession over the next twelve months, believing low unemployment, high consumer confidence (both in current and future expectations) and a lack of real economic bubbles should keep the U.S. on a modest but durable growth path. I would love to turn off the television and avoid the non-stop insinuation I'm an idiot. But as we lecture constantly on the need to seek contrary opinion, blissful ignorance and Jeopardy-watching are not really an option, so we might as well meet the market's fears head-on.
What has changed since the far healthier market outlook of a few weeks ago when the S&P 500 hit an all-time high of 2,945.83 on April 30? The most obvious catalyst has been the serious deterioration in trade talks with China and the implementation of 25% tariffs on about $300 billion in Chinese imports. From a simple GDP math standpoint, the tariff impact is not severe, with estimates ranging from -0.1% to -0.4% over the next couple of years. However, unlike previous tariffs which had a relatively minor impact on U.S. consumers, the new tariffs could bite into far more goods that end-buyers actually purchase. Further, the trade battle has had a stifling impact on business investment and sentiment, which has begun to show up in manufacturing data.
Is all this enough to derail growth? The U.S. Treasury curve is clearly saying, "Yes!" The Fed's preferred measure of curve inversion - 3M T-bills to 10Y T-Notes - has inverted convincingly, which historically has been a good predictor of recession. The market's baseline interpretation is the Fed made a policy error by tightening rates too much. We are less convinced. It is difficult to see how the December rate hike has dramatically inhibited growth. And if the market's angst is trade-related, how is the Fed going to counter a political decision which could be reversed over a weekend? More likely, risk market investors are seeking reassurance the Fed put still exists and are not above bullying the Fed into reversing policy and calming the waters. And why not? It certainly worked in December.
I think the Fed - and Chairman Powell in particular - are at a critical crossroads. If policymakers abruptly retreat from their patient and data-dependent path, the institution risks becoming the market's lapdog and in turn, may as well just dump forward guidance. I mean really, aren't bond traders saying, "When we want your opinion, we'll give it to you"?