One More Reason to Doubt the Stock Market Rally

My Comments: I’m now out of the markets with the exception of a Vanguard fund focused on high dividend yield stocks. And I may get out of that today… or not…

By Daren Fonda \ Nov. 30, 2018

Dovish comments by Federal Reserve Chairman Jerome Powell sent the stock market soaring on Wednesday. But bond investors yawned at the news. So who has it right?

The fixed-income crowd, according to economist David Rosenberg, chief economist and strategist at investment firm Gluskin Sheff.

Rosenberg, a longtime bear, has been warning that the U.S. economy isn’t as healthy as it might appear. Scores of indicators point to underlying softness, including a widening trade deficit, declines in home sales, weaker capital investment in equipment, and a slowdown in consumer spending as higher interest rates start to bite.

Add it all up, and the economy’s tax-cut fueled gains could be short-lived. And if the Fed really does pause in increasing rates-the stock market’s big hope-it would signal a recession coming sooner than expected

“The irony with Powell is what history tells us about what happens when the Fed pauses,” Rosenberg tweeted on Thursday. “The inevitable recession starts six months hence. The bulls should pray he has reason to keep tightening!”

While the stock market surged Wednesday, bonds held steady. Bonds, in theory, should be rallying on signs of a new dovish stance at the Fed. But as Rosenberg points out, yields at the front end of the Treasury curve (the most sensitive to Fed rate policy) barely moved. The two-year Treasury yield fell two basis points, or hundredths of a percentage point, to 2.8% after Powell’s comments. “As usual, the’bondies’ have the story right,” he wrote in a note.

At the center of the tug of war between stock and bond investors is the “neutral” federal-funds rate-the Goldilocks point at which it’s neither stimulative nor restrictive to economic growth. History shows that the neutral rate lies 100 basis points below nominal growth in gross domestic product. Nominal GDP growth in 2019 is likely to average 4%, Rosenberg estimates, which would put the neutral fed-funds rate at 3%.

But the Fed’s base case for nominal GDP growth is 4.5% in 2019. If that turns out to be the case, the neutral fed-funds rate would rise to 3.5%, up from the actual level of about 2.25% now.

Either way, he maintains, markets are pinning their hopes on the funds rate topping out at 2.5%, a level it would reach with just one more 0.25 percentage-point increase. But that may be wishful thinking. The Fed doesn’t have a great record in ending a tightening cycle before it tips the economy into a recession, indicating it waited too long.

“The Fed has not once completed a tightening cycle without raising the funds rate above neutral, even during the’soft landing’ episodes in the mid 1960s, mid-80s, and mid-90s,” Rosenberg writes.

If he’s correct, the stock market rally will soon peter out. Enjoy it while it lasts.