Fed’s about-face, interest rates, earnings
Bob: Marc, as you know, it clearly is all about interest rates and earnings when it comes to stock prices.
The Fed’s been raising rates for a number of years now. They started in December of 2015. They stopped this last December. And now they’ve done a 180-degree shift where everybody is discussing the likelihood of the Fed lowering rates now.
I think it’s important to remind investors why it matters when rates go down. If you think of a company’s value, you look at their earnings into infinity and then discount by an interest rate to come up with a current value for the company. The lower the interest rate factor that you use results in a higher value. So we’ve always been fond of lower interest rates. It appears that we’re just on the cusp now of the Fed starting to lower rates for quite some time to come.
Marc: Right, Bob. The Federal Reserve meets this week, and for the first time in years, it looks like they’re going to be discussing interest rate cuts rather than raising interest rates.
And what’s interesting is back in 2012, the Federal Reserve came out with what they call their dot plot. And basically what that is is a chart where every member of the fed funds committee lays out what they think the fed funds rate is going to be over the next year, to three years out.
And it’s clear from what we’re seeing and hearing out of Powell and out of some of the other members that they’re looking at lower interest rates. And that’s real interesting because that’s going to be the first time where they use this dot plot as a means to kind of set market expectations, where they’re going to be setting expectations of a cut rather than an interest rate rise.
Bob: And Marc, as you know, this is a pretty dramatic shift. As recently as early January of this year, everybody thought the Fed would raise three, maybe even four times this year. And then by the middle of the month, Fed Chair Jay Powell did a 180-degree turn, said that, no, we’re going to respond to the problems with the tariffs by acting appropriately to potentially lower rates. Very few people saw that coming. I doubted it at the time, and then the data showed, sure enough, a month or two later that the economy was, in fact, slowing.
Marc: Exactly right. We had some kind of weak economic reports—the May jobs numbers, some others. I mean right now, the fed funds futures market is looking at a 25% chance of a quarter-point cut right here this week.
And when you look out to the next meeting at the end of July, they’re looking at a 68% probability of a quarter-point cut.
So clearly, the market is expecting the Federal Reserve to lower the fed funds rate. We’ll see how that plays out, but right now that’s what the money says.
Bob: Economists are talking about how the effectiveness of lower rates may be, in fact, fading. As recently as 1980, 25% of the economy was construction and manufacturing—they’re very sensitive to lower interest rates. And now, construction and manufacturing is only 13% of the economy. So, the sectors that are most sensitive to lower interest rates are now a shadow of their former selves.
Marc: That’s right. And then you take a look at they don’t have quite as much powder in their magazine, so to speak. Because right now the fed funds rate is between 2.25% and 2.5%. So, they can lower the fed funds rate, but they don’t have as much room as they did when the fed funds rate was at 3%, 3.5%.
Bob: Or higher. Typically, they lower by five full percentage points—500 basis points— into a recession.
And, as you point out with the federal funds target between 2.25% and 2.5%, they don’t have the ability to reduce 500 basis points at this point in the cycle.
Marc: Right. It’s clear the market is expecting a rate reduction. I think there’s going to be a lot of disappointment. We’re going to have to wait and see what the language out of Chairman Powell is. He’s been very dovish recently in a lot of his comments.
I’ve got a feeling that’s going to continue.
Bob: Marc, one of the first things I got taught managing money professionally is don’t fight the Fed. If the Fed is raising rates, you want to be careful. If the Fed is lowering, you want to get enthusiastic about stocks. So, this comes at an interesting point in the market cycle, where we’re about to enter the longest period of expansion in the nation’s history.
Marc: Right. July will mark the longest expansion in history, if we get there. I think obviously we will. And we’ll see where it goes from there.
Bob: So, just one more comment. We’ve talked about interest rates so far. It’s also about earnings. The stock market is pretty accurate as a forward indicator. The market sold off, as you know, in the fall of last year, correctly forecasting that earnings would go negative for the first quarter. And now with the market up quite a bit for the year, it’s correctly, in my opinion, forecasting that earnings are supposed to turn positive this summer and then head up 6%-7% or more by the end of the year.
Marc: Right. You’re comparing against prior year, and obviously last year was big for earnings, so maybe the numbers won’t be quite as big as they were before, but still, good positive gains towards the end of this year.
Bob: Thank you. Marc.
Interest rate matters for investors, a Money Talk Video with Brian Kilb
What slowing growth means for investors, a Money Talk Video with Bob Landaas and Kyle Tetting
How to handle fears of recession, a Money Talk Video with Bob Landaas and Kyle Tetting
(initially posted June 26, 2019)
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