Some comments on the shutdown, Fed policy and the markets

On today’s market action

Today saw the S&P 500 rise for the fourth straight day, the longest up-streak since September. And that puts us up 10% since Christmas Eve. Crude is rallying too , with WTI gaining almost 5% on the day to $52.18. What’s more, yesterday, investors rotated $745 million out of from Vanguard’s $27.2 billion short-term bond ETF. That’s the fund’s biggest one-day withdrawal ever – and it tell you the bulls are back.

I told you there were no signs of recession anywhere on the horizon and so I found it hard to believe that we were going to see a sustained bear market. Moreover, historically it’s weakness in the credit sector and the real economy that calls the shots, leading to bear markets, not vice versa. What I believed then – and even more now that markets have rallied – is that we are going to see volatility, a yo-yo-ing up and down while investors try to figure out how much longer this expansion and bull market are going to last.

Nos, you could make the argument that it’s the Fed doing this by talking dovish. All of the headlines about comments Fed officials have been making show the Fed has turned dovish. And the markets are taking that on board. They are pricing in no rate hikes in 2019, with the first rate actions cuts at the December 1919 and January 2020 meetings. Essentially, the markets fought the Fed and prevailed.

The shutdown is starting to worry me

Right now, it looks like the over-tightening scenario is off the table because the Fed has backed down. The Goldilocks outcome, then, is the Fed on hold, with the economy holding up well as they reassess. But, there’s also another negative scenario, where the Fed is on hold and the economy deteriorates significantly. The government shutdown is certainly adding to the risk that that scenario materializes. The latest news as that Trump stormed out of a meeting with Democrats on the shutdown because he sensed there would be no movement from them on the Wall. Essentially, he threw a temper tantrum because he couldn’t get his way and he is frustrated that the shutdown is going to hurt the economy and cost him standing with his base.

I think that’s a potential outcome here given how long this has been going on. Look at the end of this story from the New York Times that has caused a stir:

“We can handle a month or two, but if it gets much longer than that, I’m going to look for another job — a job in the private sector,” Ms. Sims said of working without pay.

She blamed Mr. Trump for the shutdown, a point on which she disagreed with her husband and most of her colleagues. “This definitely is making me more political than I have been in the past,” Ms. Sims said. She has been researching how Congress passes budget bills.

“My stance is that if there’s a wall, they’re going to find a way to get past it — legal or not,” Ms. Sims said.

“I believe there should be a barrier,” her husband countered.

A few miles away, another prison employee, Crystal Minton, accompanied her fiancé to a friend’s house to help clear the remnants of a metal roof mangled by the hurricane. Ms. Minton, a 38-year-old secretary, said she had obtained permission from the warden to put off her Mississippi duty until early February because she is a single mother caring for disabled parents. Her fiancé plans to take vacation days to look after Ms. Minton’s 7-year-old twins once she has to go to work.

The shutdown on top of the hurricane has caused Ms. Minton to rethink a lot of things.

“I voted for him, and he’s the one who’s doing this,” she said of Mr. Trump. “I thought he was going to do good things. He’s not hurting the people he needs to be hurting.”

Trump voters will leave him at some point if this keeps up

These are Trump voters, Trump’s base, the people who he believes want him to stand firm on the wall. But the longer the shutdown goes on, the more of these people are going to defect from him and blame him for their personal misery. Look at how Crystal Minton put it: “I thought he was going to do good things. He’s not hurting the people he needs to be hurting.”

This whole idea of wanting Trump to hurt others is something I may bring up at a later point because it says something about human psychology. But, for now, while, overall, voters blame Trump for the shutdown, Republican voters don’t. They blame congressional Democrats.

And this is true even though Trump explicitly took responsibility for the shutdown a few weeks ago. So, they’re still with him, but for how long? And how weak will that make him vis-a-vis Congressional Republicans, who have to do his bidding for fear of their base, which supports Trump?

To me, this has the makings of a climbdown. If Trump doesn’t climb down soon though, he’s going to suffer serious erosion in his base. It will make him much more vulnerable politically. And once he loses his base, it could even make him ‘impeachable’.

Thoughts on Fed policy

Meanwhile, I’m thinking about the Fed as having faced two markets with vastly different ‘equilibrium’ interest rates. No one is talking about this though.

For example, people like Danielle DiMartino Booth, who were once in awe of Powell’s more hawkish approach are now talking about the Powell Put. Their bailiwick is the market, where there’s been considerable excess, particularly in places like leveraged loans. And so, they are disappointed that Powell is backing down on hikes, apparently because markets threw a hissy fit, hence the Powell Put.

On the other side of this debate, you have people like Dartmouth Econ Professor Danny Blachflower, who thinks rate guidance is too aggressive given the slack that still exists in the labor market and a projected slump in growth.

Who’s right?

I think they are both right, meaning that the Fed’s policy rates are low from a credit excess perspective, and should have gone up much sooner in the cycle and more aggressively.

At the same time, only now are wages rising robustly for many Americans. And to cut that trend short by raising rates and engineering unemployment to add slack and prevent inflation seems perverse. The Fed is dooming the working and middle classes to lower wage growth, even while the rich who own most of the investable assets have already seen a massive uptick in wealth from asset prices, due to market froth.

There isn’t a magic neutral interest rate. That’s a ridiculous and simplified fiction. Instead, there are multiple ‘clearing’ interest rates applicable to different sectors of the economy and different asset markets. And so, while the interest rate might be low for investors in shale oil, it may not be for those wanting better pay in the gig economy.

A lot of this has to do with policy choices. But, we’re here now. And that’s water under the bridge.

Going forward

Right now my baseline, then, is good Q4 numbers in line with the GDPNow tracker’s 2.8%. This will be followed by a modest weakening in the first half of the year keeping the Fed on hold. To the degree Trump digs in his heels and keeps the shutdown going, expect that weakening to become more severe. And then the prospect of Fed cuts does come into play for late in 2019.

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