A Long, Cold December
I could just scream! After a
lengthy stretch of strong economic growth and stock market gains, the
inevitable correction arrived with force in the fourth quarter, culminating
with a December that can only be described as “tres terrible!” Stocks of all industries sold off
relentlessly in volatile trading sessions featuring price changes of 2% to
3%. US stocks erased all gains in 2018
and ended the year down 4% to 6%. If it
is any consolation, stocks around the world were much worse. China’s indices, for example, were down by
25% to 30% for the year.
For the month of December, 2018, the major indices were down about 9%,
which was the worst December stock performance since 1931. Three contributing factors caused the
correction: a tipping point of rising
interest rates driven by the Federal Reserve, the ongoing trade wars, and the
government shutdown. The worst trading
day was actually on Christmas Eve, when stocks reached their lows for the
year. Then, surprisingly, we actually
got a Santa Claus rally (for the last week of December and the first two
trading days of January averaging +1.4% since 1969, that brought stocks up over
4%. So we spent Christmas day feeling
bad, but for anyone who hung in there, the month at least ended on a good note.
Meanwhile, while stocks were displaying their volatile price swings, US
Treasury yields for longer-dated issues were declining by .45% to .53% from
their highs in November, on the 2 year and 10 year Treasuries,
respectively. The yield curve continued
to flatten from 2 years to 10 years to only .19% at year-end, 2018, down from
.52% at the end of 2017. The spread
between 3 month and 10 year Treasuries is not much better, dropping to .23% at
the end of 2018, from 1.02% one year earlier.
At one time, former Fed Chairman Greenspan said that a healthy yield
curve had .50% between 2 and 10 years.
Fears of the dreaded inverted yield curve rippled through the markets as
investors kept seeing a Fed that would raise interest rates forever.
Inverted Yield Curves
An inverted yield curve occurs when the Federal Reserve raises
short-term interest rates too much and longer-term rates are lower or falling
below the short-term levels. Currently
the yield curve is not inverted, with the 3 month Treasury yield at 2.42% and
the 10 year at 2.69%, but the cushion is only .27%; the Fed recently said that
a cushion of .40% is more comfortable.
History has shown that inverted yield curves precede recessions by 18 to
24 months on average, as we saw in 1990, 2001, and 2005. Since 1960, all six recessions have been
preceded by inverted yield curves.
Investors are fearful because they see this type of curve hurting
economic activity. Indeed, banks
generally pull back on lending if longer-term loan rates are less than their
cost of funds, which are generally based on shorter-term rates.
The Fed has repeatedly said that they do not want to increase short-term
rates if that would cause a yield curve inversion. This leads many, including me, to believe
that they will stop raising interest rates and will “wait and see.” It is actually a good strategy. Fed policy works with a long lag, so letting
the effects of earlier rate hikes catch up would be good. Long- term rates have fallen back and should
only reverse and trend higher if inflation becomes an issue. Inflation is currently stable or falling.
Money supply (M2) growth has slowed dramatically in the past few years,
from a 6% to 7% year-over-year pace just two years ago to a pace under 4%
today. I am one of the “old school”
advocates of monitoring money supply because it is used in some formulas for
determining GDP growth. M2 growth has
slowed because of Fed tightening, which includes both the raising of short-term
rates and the reduction of their balance sheet investments by $50 billion per
month, draining money from the system.
Rates are too high and the Fed is too tight.
Large Hadron Collider Update
Many of you that have read my newsletters or seen my economic
presentations in the past know about the Large Hadron Collider, the world’s
most powerful atom smasher located in a 17 mile long tunnel deep under the
mountains of Switzerland. Back in 2008,
the LHC started up with a bang and led to all kinds of new physics particle
knowledge. The discovery of the Higgs
Boson particle so far is the pinnacle of the research. But more physics discoveries (and updates
from me) will have to wait. The LHC was
shut down in December, 2018 for two years for maintenance and upgrades. How much faster and harder can they smash
All indications are that GDP growth is slowing, reverting back to its
“new normal” range than has been in place since 2011 of 2.0% to 2.5%. I believe that GDP will be stuck in this
range, mostly due to the effect of high debt levels of consumers, businesses,
and especially government. Most
economists and the Federal Reserve expect growth in 2019 will be 2.3% to 2.6%
and lower in 2020. Some are calling for
a recession in 2020, but we should be able to avoid it if the stubborn Fed
stops raising rates. The slowdown in GDP
was inevitable because of higher interest rates. A tightening campaign that started in
December, 2015 and has totaled 2.25% has basically offset the boost from tax
cuts and the tightening also succeeded in flattening the yield curve. The Fed has made cautious statements in the
past few months about not wanting to raise short-term rates high enough to
invert the yield curve. No one wants
that, if it will predict a recession in 18 to 24 months.
I believe that the Fed will not raise rates in 2019. They will switch to fighting inflation that
never came (sorry, Phillips curvers!) to supporting the economy and trying to
avoid recession. Supporting this belief
is the fact that Fed Funds and Eurodollar futures, which trade on short-term
rates, do not contain any rate increases in 2019. But remember, just because we believe in no
rate hikes does not mean that the Fed will always listen. They will do what they want.
Despite a very low unemployment rate of 3.9%, inflation and inflationary
expectations have been falling and are at or below 2.0%, which is the Fed’s
target. Job growth continues to support
the current expansion, which is now 9.5 years old. And, if GDP expands through July, 2019, which
is expected, we will set a new duration record of 121 months for a recovery,
albeit the weakest recovery since World War II.
Supporting continued growth will be consumer spending, jobs, and falling
oil and gasoline prices. Hindering
growth will be continued huge government deficits and the ongoing shutdown.
The time has come for a Fed
pause. The markets are a force to be
reckoned with, as Chairman Powell has now acknowledged, and their volatility of
the past several months, a flat yield curve, and slowing economic data have a
newly humbled Fed ready to stop their tightening campaign. Thanks for reading!
Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.