July 15 2019 Market Update
What are We Supposed to Think About Interest Rates?
June was an interesting month for markets: despite a weak jobs report in May and growing evidence that the economy could be downshifting, markets soared across the board. In fact, the Dow had its best June since 1938, and investors with 60 percent in stocks and 40 percent in bonds had their best first half of a year since 1997.
Part of this was driven by the market’s conviction that the Federal Reserve would be cutting interest rates to support a continued economic expansion. As of July 2, 2019, the futures markets had priced in 100% certainty of a rate cut after the Fed’s July meeting.
But a much stronger jobs report for June again threw market observers off balance, and the intense scrutiny of each report raises two important questions for investors: how important is jobs growth for the Fed, and if companies are hiring and the economy is still growing why would we need to reduce interest rates?
Let’s take a look at some of the more complicated issues underlying recent market moves.
What’s Going on With Jobs?
Employment is a critical input into the Fed’s view of the economy. Unlike other central banks, the Fed has a dual mandate: to support employment and to maintain low but positive inflation, with a target annual inflation rate of 2 percent.
As a general economic principle, focusing too much on one can come at the cost of the other: so maximizing employment could force wages up and spike inflation, while minimizing inflation can slow growth and weaken employment.
Thus the Fed’s goal to balance inflation and employment in a way that maximizes employment without pitching inflation past 2 percent.
That’s part of what makes the current situation so interesting. Inflation has been low, but at the same time, the unemployment rate has also fallen to reach historic lows.
Jobs growth has also slowed overall. While the June jobs report brought a lot of enthusiasm, looking at year-to-date jobs growth we can see that it’s down from 2018 and closer to levels we saw in 2016 and 2017. The spike in 2018 was largely due to tax reform, so most economists consider it to be an aberration more than anything.
But overall, as the Fed looks at these and other data points, it might see that there is room to further stimulate economic growth, and thus boost inflation a bit, without negatively impacting the unemployment rate.
Is there a Real Reason for a Rate Cut?
Of course, the jury is out on what will happen next: as you might imagine, there is always disagreement when it comes to what the Fed should or should not be doing.
The arguments for a rate cut are partially related to inflation, as we noted above, but also come down to providing support for a few sources of weakening economic data.
For example, one broad measure of business confidence plummeted to its lowest level in history. The Morgan Stanley Business Confidence Index fell to 13, its lowest level since 2008. A reading above 33 is considered the threshold for economic growth. The manufacturing sub-index fell to zero, its lowest on record.
A national index of factory activity also dropped in June to its lowest point since October 2016, the third decline in as many months. While the index is still in “expansion” territory with a reading of 51.7 (those above 50 are considered expansive), it has been tiptoeing down. Wavering business sentiment appears to be echoed by consumers: consumer confidence also slipped in June. 
All of these indicators have been driven primarily by trade tensions with China and Mexico and the related uncertainty in trade policy.
The Challenge of Leading Indicators
You’ve probably heard the expression “perception is reality.” In our experience, when it comes to markets this is often true. Whether it’s animal spirits, panic, or a sense of growing concern about the economy, perceptions drive behavior, which can have a real impact on results.
In the case of the Fed, the justification for a rate cut might be debatable. After all, reducing the cost of borrowing right now doesn’t seem like an urgent matter – borrowing costs are already incredibly low, and it’s unclear that reducing those costs further will materially encourage greater economic growth.
However, the market’s confidence has arguably been very reliant on a rate cut. As expectations for a rate cut wavered following the July 5 jobs report, equity markets fell and anticipation for forthcoming (as of this writing) testimony to Congress by Fed Chair Jerome Powell took on new urgency.
Along with forthcoming inflation data, sentiment is another data point for the Fed – part of the dance between Fed statements and market interpretations, one that can be challenging for Fed officials to balance (and for investors to parse).
We are not overly concerned about the prospects of a significant downturn right now. But we are also not partial to wearing rose-colored glasses. As you’ve probably heard us say, markets go up and markets go down, and the best preparation for either situation is a balanced view and a risk-managed approach to investment management.
If you have any questions as we head into the next month, please don’t hesitate to check in.
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 https://www.richmondfed.org/publications/research/economic_brief/2011/eb_11-12 and https://www.federalreserve.gov/faqs/money_12848.htm
 For a useful discussion on the price of credit versus market expectations, please see https://www.bloomberg.com/news/audio/2019-07-05/surveillance-kudlow-to-fed-take-back-rate-hike-podcast
At about 2:45, economist Julia Coronado discusses the issue of market expectations in depth.
 Source: https://www.wsj.com/articles/global-stocks-fall-as-u-s-rate-cut-prospects-recede-11562563827