Powell's Two Words Move Markets

Two words from Fed Chair Jerome Powell moved markets last week: “JUST BELOW.” He was talking about short-term interest rates, which are just below neutral, a Goldilocks level that is designed to neither speed up-nor slow down-economic growth. Powell’s assessment was a change from a comment he made in early October, when he said rates were a “long way” from neutral. 

Investors immediately bet that while the Fed will hike by another quarter point in December, further increases may not be necessary. That was good news for stocks, which jumped after the remarks and brought three of the four major indexes out of correction territory.

What prompted Powell’s change of heart? There are signs that some sectors are showing the impact of the Fed’s three-year rate hiking cycle.

Topping the list is the housing market, which has slowed down markedly. New home sales slumped in October to the lowest level since March 2016, with every region sliding. The combination of higher mortgage rates; increasing costs for both labor and material; and the impact of the new tax law, has negatively impacted the market. Housing accounts for approximately one-sixth of the economy, so that fact that it is slowing down, may have influenced the Fed Chair.

Additionally, the central bankers are also keeping an eye on business investment, which after jumping in the first half of the year, has downshifted and the impact of tariffs on the farming and auto sectors.

In addition to Powell’s two little words, the Fed published its inaugural Financial Stability Report, which focuses on potential vulnerabilities in the economy. Powell described the risk as “Moderate,” but outlined the four areas that bear watching:

1. Elevated valuation pressures: Investors have shrugged off risk for many assets, especially those related to corporate debt and commercial properties. Powell said that while valuations are high relative to the post-crisis era, “they are short of the levels they hit in the pre-crisis credit boom.” Right now, the Fed does not “see dangerous excesses in the stock market.”
2. Excessive borrowing by businesses and households: Household borrowing has increased as incomes have gone up–that’s normal. But business debt relative to GDP is historically high and there are signs of deteriorating credit standards. “Some of these highly leveraged borrowers would surely face distress if the economy turned down,” but while investors may get stung on these risky bets, the Fed does not believe that the overall system would be threatened.
3. Financial sector leverage/Funding: Unlike ten years ago, the nation’s largest banks are strongly capitalized (and hold more liquid assets), and are using less borrowed money. Insurance companies have also strengthened their finan-cial position since the crisis. Translation: A 2008-style credit crunch isn't in the forecast.

The noted near-term risks, including: Brexit/Euro-area fiscal challenges; Problems in China/other emerging markets; and Trade tensions/geopolitical uncertainty.

Have a money question? Email me here.