Don Stammer is an adviser to Stanford Brown Financial Advisers. The views expressed are his alone.
Sentiment in financial markets swings widely. Sometimes - as in early 2008 - a sudden switch in market moods correctly anticipates an imminent, and lasting, change in investment returns. More often, sharp changes in market sentiment are over-done; they soon reverse; and many are quickly forgotten.
Investors who look for shades of grey in the investment outlook, who keep a sharp eye on underlying fundamentals, and who don’t feel need to follow the majority view, have opportunity to benefit from market over-reactions.
Recently, the majority view in investment markets has been expecting sizeable cuts in the US cash rate, starting later this month - and anticipate that other central banks will adopt more accommodative monetary settings, as China and Australia have done recently.
As a result, bond yields have collapsed, bond prices (which move inversely with bond yields) have risen, and share markets have surged. But investors holding cash or short-dated term deposits are feeling, or expect to feel, pain from low cash rates.
Is the prevailing view of a markedly lower US cash rate well-based? And, if the Fed delivers the rate cuts markets are now primed for, would the good times for bond investors and share investors continue? Let’s start by looking back on the swings since late last year in market expectations for the US cash rate.
The wild ride in market expectations:
In much of the second half of last year, the expectation was for two or three increases in the US cash rate during 2019. However, in mid-December, the mood of investors soured. Fears developed that any increase in the cash rate would choke the US economic recovery. Bond yields fell and share markets were heavily sold. In January and February, the mood changed again, after the Fed stated it would be “patient”, to the view the cash rate would be left unchanged. In May, sentiment started factoring in one or two reductions in the cash rate before the year ends.
In June, fears intensified that the US economy would slow; and the Fed’s guidance moved to “sustaining the economic upswing”. Expectations of a lower cash rate intensified. Many investors are now forecasting the Fed will cut a half percentage point from its cash rate in July followed by smaller moves in September and January; others anticipate cuts of a quarter of a percentage point in each of July, September and December. Either way, the US cash rate is expected to end the year in the range of 1.5/1.75 per cent, well below the target of 2.25/2.5 per cent announced last December.
What can we expect?
In my view, investment markets are exaggerating both the scope the Fed will have to cut its cash rate and the likelihood that bonds and shares continue their powerful rallies:
Some profit taking in bond markets is likely as investors: reduce the probability of an early US recession; factor in the skinny running yields that bonds now carry; and are surprised by occasional signs of upward drift in growth of average US wages.
The big rally in shares in the last seven months has left US share valuations moderately high though not badly stretched. There’ll likely be times when investors need re-assurance that profits growth will be high enough to underpin further gains in average share prices.
Prospects are that shares and bonds will at times move in opposite directions. Shares would likely benefit relative to bonds should inflation pick up even slightly, or were the risk of a US recession to decline (say because peace breaks out in the trade and technology wars). Bonds would likely benefit relative to shares if the odds are raised of recession in the US.
The safest course for investors might be to build up cash holdings build up a little, even though returns on cash are low, and wait for better opportunities to top up holdings of shares and bonds.
The pros and cons of big cuts in the US cash rate:
The widespread expectations for sizeable cuts in the US cash rate reflect these concerns. Business conditions in the US and other countries are thought to be slowing. The tariff and technology wars are hurting. Risks of a US recession have increased. The boost to spending from the Trump tax cuts is fading. US inflation has got stuck below the Fed’s target of two per cent. US interest rates are “too high” relative to those in other countries.
A lot of pressure, some of it self-serving, on the US central bank comes from President Trump and from the market. One international bank worded its threat this way: “With the market now pricing about a full cut by July and nearly 0.4 of a percentage point of cuts through September, failure to satisfy market pricing risks spilling over negatively into financial conditions, which could ultimately push the Fed to cut anyway”.
The counter view on the outlook for the US cash rate, held by a minority of investors and commentators, says a significant reduction in the cash rate is unnecessary, and even dangerous. It’s “the rate cut the economy doesn’t need but markets do”. The US economy is growing at only a little below its trend rate. Risks of a US recession remain low. The US labour market is the strongest for fifty years. Growth in average wages is gradually picking up. An easing in monetary policy couldn’t be relied on to fine tune the small increase in inflation to two per cent, but would pump up asset prices.
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