New York, USA - 28 Nov 2018 The speech of Federal Reserve Chairman Jerome Powell, to the Economic Club of New York, cast a bright picture of the U.S. economy Wednesday and appeared to suggest that the Fed might consider a pause in its interest rate hikes next year to assess the impact of its credit tightening

By: Lyn Alden

The Federal Reserve had a big impact on markets last week. Fed Chairman Jerome Powell gave a speech last Wednesday at the Economic Club of New York that immediately sent markets soaring upwards. The Dow Jones Industrial Average Jumped 600 points in one day.

For context, back in early October, Powell gave a speech that is widely seen as one of the key catalysts for the U.S. stock market sell-off over the past two months. In that speech, he said Federal Reserve interest rates are “a long way” from neutral, implying that the Fed would continue to be hawkish on consistent interest rate hikes going forward. This hawkish approach drew sharp criticism from people ranging from President Trump to stock pundit Jim Cramer, but also drew some support from former Fed chairwoman Janet Yellen and others in the industry.

Higher interest rates are used to combat inflation, but can make mortgages more expensive, can pull asset valuations down, can pop credit bubbles, and can invert the interest rate yield curve. The neutral rate is the theoretical rate that is neither stimulatory or restrictive on the economy.

Rates are currently low by historical standards:

Source: Board of Governors of the Federal Reserve System

Last Wednesday, Powell’s Economic Club speech had a more dovish tone, which sent markets upwards. He said that interest rates are “just below” the broad range of estimates for what constitutes a neutral interest rate at this time and insisted that the Fed would be data-dependent on its approach to changes in interest rates. This calmed markets by implying that rate hikes might not be as frequent as earlier implied.

Powell’s specific language is carefully-worded and not quite contradictory to his October statement even though it’s a big change in tone. It’s more about his choice of words and emphasizing the flexibility and data-dependency of the Fed. According to recent Federal Reserve dot plots, the neutral rate is estimated by members of the Federal Open Market Committee to be between 2.5% to 4%, with the median around 3.25%. Right now, the interest rate is at 2.25%. It’s still “a long way” from the median, but also “just below” the bottom end of the range of estimates for what constitutes this market’s neutral rate.

The market statistically expects the Fed to raise rates by 0.25% in December up to a 2.50% rate, but then perhaps fewer rate increases in 2019 than originally planned, depending on inflation and other factors.

Financial Stability Report

The Fed also released a new 46-page financial stability report last week, with the purpose being to assess the resiliency of U.S. financial system. In the report, they emphasized four main categories of risk.

1. Elevated valuation pressures

2. Excessive borrowing by businesses and households

3. Excessive leverage within the financial sector

4. Funding risks related to liquidity

The summary of the report is that asset valuations are relatively high by historical standards, which includes stocks, bonds, and real estate, and that investors seem to be taking on substantial risk. However, household balance sheets are relatively strong; household debt as a percentage of GDP has been stable. Corporate balance sheets on the other hand are more concerning, with historically elevated levels of debt. And that’s where a lot of the especially problematic investor risk is: in leveraged loans and high yield “junk” bonds, which fortunately are not present in the TSP.

This chart from the report shows changes in business debt (red line) and household debt (black line) as a percentage of GDP over time. As you can see, relative corporate debt is at record levels while relative household debt is considerably below where it was a decade ago:

The report also highlighted a few primary near-term risks that I’ve discussed here on FEDweek in previous weeks. Britain and Italian disagreements with the EU regarding Brexit and Italian government debt respectively are risks to Europe, the I Fund, and global financial stability, including potentially impacting U.S. markets. Trade tensions between the United States and China may make business investors hesitant to do more capital spending until they have more clarity regarding supply chains, and declines in emerging market economies could spill over into the United States.

The paragraph in the Fed’s report that was most-cited by financial media was this one:

“An escalation in trade tensions, geopolitical uncertainty, or other adverse shocks could lead to a decline in investor appetite for risks in general. The resulting drop in asset prices might be particularly large, given that valuations appear elevated relative to historical levels. In addition to generating losses for asset holders, a significant fall in asset prices would make it more costly for non-financial businesses to obtain funding, putting pressure on a sector where leverage is already high. Markets and institutions that may have become accustomed to the very low interest rate environment of the post-crisis period will also need to continue to adjust to monetary policy normalization by the Federal Reserve and other central banks. Even if central bank policies are fully anticipated by the public, some adjustments could occur abruptly, contributing to volatility in domestic and international financial markets and strains in institutions.”

On Saturday, President Trump and President Jinping of China met at the G20 summit in Buenos Aires, and reportedly agreed for their teams to work over the next three months on a trade agreement. Up until this meeting, President Trump was publicly planning on raising tariffs on $200 billion worth of Chinese goods from 10% to 25% on January 1, but now that date will reportedly be delayed until around March 1, which gives both sides time to work out trade details.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.