I started this letter last night, made revisions this morning during pre-market hours and finalized the letter just before noon today. This letter does not contain recommendations. The intent of this letter is to educate and provide perspective, given the volatility of financial markets over the past 24+ hours.
Why did the market drop?
Rarely is there a single reason for a market sell-off. Two exceptions that come to mind are:
- Monday, September 17, 2001, when the markets re-opened post-9/11
- Monday, August 8, 2011, when the market dropped after U.S. debt was downgraded after the market had closed on August 5th.
Most of the time, however, markets decline because investors are reacting to multiple issues. Here are some of the many headlines that are impacting markets – the length of this article is in direct relationship to the complexity of how various headlines collide to cause markets to become volatile.
Bonds, interest rates and yields
Interest rates have been historically low for years, so any investment product offering a larger interest rate (i.e. yield) will attract investors away from products paying a lower interest rate. The value of bonds currently in circulation tends to decrease when interest rates increase, simply because they are no longer in demand. Investors demand the new, larger interest rate products.
The Barclays Aggregate Bond Index is a widely used bond market proxy and it is -2.49% year to date 2018 (through 10/10/18). This means the total return of bonds are negative for 2018. Total return is the sum of interest payments plus the change in value of bond prices. Summary: in 2018, the collective interest payments from bonds combined with their change in value is -2.49%.
The 10-year Treasury bond (also a widely used benchmark to measure interest rate changes) is now yielding 3.23%. Twelve (12) months ago, the yield was closer to 2.30% and at the beginning of 2018 was 2.60%. The 10-year Treasury yield has increased over 100 basis points (a basis point is .01%) over the past 12 months. Incidentally, in December 2015 the 10-year Treasury yield was approximately 2.20% – December 2015 is when the Federal Reserve first began increasing the federal funds interest rate. Conclusion: Although the Fed began increasing interest rates nearly 36 months ago, the majority of the increase in yield for the 10-year Treasury yield has only occurred during 2018.
Federal Reserve (Fed)
The Fed controls only two interest rates: the federal funds rate and the discount rate. Of the two rates, the federal funds rate attracts the most attention and is the “rate” referred to when the media is discussing the Fed interest rate decisions. Typically, lowering the fed funds rate will attract more borrowing from consumers and thus increase the supply of money into the economy. Conversely, increasing the fed funds rate will decrease borrowing from consumers and thus will reduce the supply of money flowing through the economy. The raising and lowering of the federal funds rate is only one of the “monetary policy” tools used by the Fed, and because it is so transparent, perhaps some investors might believe this is the only tool. Another tool (or strategy) the Fed uses to try and influence the money supply is to buy or sell securities. Buying securities will put more cash into the economy – recall that the Fed purchased trillions of dollars of securities after 2008, along with lowering the federal funds rate, using both tools to attempt to increase our money supply and stimulate the economy.
In May 2013, bonds had one of their worst months in decades. Ben Bernanke was the Fed chairman at the time. In June 2013, Bernanke held a press conference (really, there were multiple press releases both in print and video, from Bernanke and other Federal Reserve presidents – but for simplicity of this letter, I’ll reference Bernanke as the mouth piece for the Fed at the time). Since the Fed was established in 1913, there had been no telegraphing of what the Fed desired as their future course of action. (Some reading this might recall the “briefcase indicator.” Alan Greenspan, former Fed chairman, carried a briefcase and market analysts would attempt to predict Greenspan’s thoughts on interest rates based on whether the briefcase appeared to be thin or thick. At the time, that was the extent of our sophisticated analysis related to future interest rates.) In June 2013, Bernanke essentially announced the Fed would now begin communicating (to the public, investors, analysts…everyone) their expectations for the economy and inflation, as well as their intentions for future interest rate changes. It seems to me having a dialogue within the Fed and delivering intentions months in advance of implementing policy should be viewed as a much better system than guessing at monetary policy based on a briefcase. And today’s foreshadowing has to be better than in the past when we had to wait until the Fed completed one of their monetary policy meetings and announced their interest rate decision – very often as a total surprise to everyone, precisely because there was no dialogue from the Fed to the public.
Fast forward from 2013 to today: The Fed is now two chair people removed from Bernanke (Janet Yellen replaced Bernanke, and Jerome Powell replaced Yellen), but the Fed has continued to – almost daily – remind the public of their expectations and intentions. And those expectations and intentions have not changed significantly in the past 5+ years. The target expectations have been, basically, to have full employment and 2% inflation, and the intentions have been, basically, to gradually increase interest rates when the expectations are achieved.
Recall early 2016 – a very ugly time for financial markets. One of the many reasons (i.e. excuses) for the market decline of early 2016 was essentially this: During their December 2015 meeting, when the Fed increased rates by .25% – which was the first interest rate increase in years – the Fed also “penciled in” four interest rate increases for 2016. So, after years of telling everyone to be prepared for nominal but measured interest rate increases once the economy stabilized, and after several business quarters of slow growth but improving economic data, and after increasing interest rates one time in December 2015 by .25% – financial markets reacted as though all of this was brand new information.
Including the .25% Fed increase in December 2015, prior to which the federal funds had been .25% and at which time the 10 year Treasury yielded around 2.20%, there have been eight (8) Fed rate increases. Today, the federal funds rate is 2.25% and the 10 year Treasury yield is 3.23%. Conclusion: The Fed was unsuccessful in pushing up interest rates for the first couple years of federal funds interest rate increase announcements – most of the interest rate increases throughout the economy have only occurred (or as the media sometimes says, had “lift off”) over the past year.
The last point I’ll make about Fed headlines – and they happen to be two of the most recent headlines – are from President Trump. On Wednesday morning 10/10/2018, he stated “I think the Fed has gone crazy.” This morning, President Trump stated about the Fed that they are getting “a little bit too cute.”
I’m on record as believing the Federal Reserve is doing exactly what they are supposed to be doing: evaluating employment and inflation and implementing monetary policy to keep both employment and inflation on target. The Fed has zero obligation to make the stock market or the president happy – and if the Fed were to acquiesce and begin to implement monetary policy based on the reaction of the stock market or based on the demands of a single individual, then the Fed would not be fulfilling their charge of using employment and inflation as the benchmarks for their decision making.
There is no single indicator to assess the health of the economy. Collectively, there are dozens of indicators that are tracked and used in aggregate to determine the state of our economy. My observation, based on tracking several economic indicators: the U.S. economy is in better than average health. My conclusion, relating the health of the economy to interest rates: the health of the economy is one of the reasons why interest rates have increased. Questions related to the economy – and questions that lead some investors to sell stocks and/or bonds – are whether or not the pace of inflation will accelerate, and if so, by how much, and when.
UPDATE: This morning, U.S. inflation figures for the month of September were announced. Estimates expected an increase of .2%; however, core inflation increased only .1%, meaning the annual pace of U.S. inflation is now 2.2% (instead of the 2.3% that had been expected).
My overall assessment of the U.S. economy expansion over the past several business quarters: economic expansion is precisely what investors and our government hoped would happen after the financial crisis of 2008-2009. The pace of inflation has increased over the past few years – and inflation is one of the two variables the Fed is responsible for managing. The increase in the pace of inflation is also one of the reasons why Fed has increased rates.
Trade and tariffs
I suspect if we were to guess the last time any of us heard the word “tariff” or even thought of the word tariff, it was either (1) in school, or (2) never. There is no doubt at least some of the volatility of financial markets is attributed to the ongoing-for-several-months uncertainty surrounding tariffs. What country will be impacted? Which company or companies will be impacted? How will trade routes, shipping and logistics be impacted? When will the tariffs be implemented? On what products, exactly? And – maybe most importantly – how will tariffs affect the bottom line of consumers and companies?
To say that the tariff issues are confusing is an understatement. What is for certain is that financial markets abhor confusion.
Combination of various headlines
It would be totally inaccurate to attribute the entirety of yesterday and today’s markets to the few items I’ve outlined in this letter. However, I believe a vast majority of the sell-off has been the result of these issues colliding frequently enough in recent weeks that the markets finally sold off.
As always, please call or email if you have questions.
Timothy A. Weller, CFP®