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Accommodative Fed Will Rescue Stock Market

James Hyerczyk
So far, the selling in the stock market has been orderly. I believe this is because the Fed has investors convinced that any slow-down in U.S. economic growth, accompanied by a low-inflation environment will encourage the U.S. Federal Reserve to cut rates. Low interest rates and accommodative Fed policy will eventually right the ship and slow down the selling pressure.

The major U.S. stock indexes posted another steep sell-off, leading to the sixth consecutive weekly lower close for the Dow, while the S&P 500 Index and NASDAQ Composite declined for the fourth straight week. The selling was fueled by rising trade tensions and geopolitical uncertainty.

Market volatility rose last week because of the increasing economic uncertainty and changing investor expectations. This was reflected in a surge in Treasury notes and bonds as yields plunged to multi-year lows. For some investors, the weakness in stock market was somewhat offset by the gains in Treasurys.

Are Falling interest Rates a Sign of More Problems?

U.S. Treasury yields had been falling all month, but it seems stock traders first took notice of the steep decline last week. A wave of selling hit stocks as investors finally realized the decline in yields was telegraphing a weaker economy or a recession. Up until last week, it seems stock market players thought yields were falling due to safe-haven bond buying.

During the low interest rate environment in the U.S., stocks were rallying because they offered a better yield. This time, the low yields are scaring stock market investors because they are afraid of what they may be indicating.

Is Too Much Weight Being Placed on the Short-Term Signals?

Yes, yields have fallen. Yes, Treasury traders are pricing in a rate cut. But is it too early to be talking about a recession? With most investors watching for news about U.S.-China trade relations, the drop in the 10-year Treasury rate to 2.13% last week may have slipped past them. The inverted yield curve may have also come as a surprise.

Investors seem to be attached to stories that say recessions followed past yield curve inversions. It’s a tricky signal to follow and therefore may not be the reason stocks fell last week. Furthermore, it hasn’t been a very useful signal for investors because of timing issues. According to research from Factset, stocks have risen over the following year about half the time. Recessions have followed the inverted yields, but the lag has ranged from six months to almost three years. In other words, don’t sell stocks because you think a recession is coming.

The inverted yield curve is one of several indicators used by the professionals to suggest slower growth, lower returns and more volatility ahead, it doesn’t necessarily mean a recession is coming. Furthermore, if the Fed lowers rates as expected in a timely manner, this move may actually extend the long-running expansion and bull market.

Stock Market Selling May Be Overdone

So far, the selling in the stock market has been orderly. I believe this is because the Fed has investors convinced that any slow-down in U.S. economic growth, accompanied by a low-inflation environment will encourage the U.S. Federal Reserve to cut rates.

This current break has been nothing like the October to December sell-off, which was taking place during a rising interest rate environment. Low interest rates and accommodative Fed policy will eventually right the ship and slow down the selling pressure.

Furthermore, all it is going to take to turn stocks higher is the announcement that U.S.-China trade talks are back on. Both economic powerhouses have strong incentives to resume talks and eventually will reach some type of trade agreement.

We do believe that the trade dispute is the source of the short-term weakness and volatility. Furthermore, it may be the source of a short-term economic slowdown, but it shouldn’t last long enough to cause a recession.

This article was originally posted on FX Empire

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