Given the recent gains in the stock market over the last month or so, it is clear that stock market participants believe that the country will be back on its feet in no time. Over in the fixed income space, it is another story entirely. The question is which market will be right?
The betting in the bond market is that U.S. interest rates are not only going to zero, but there is a high probability that America, like Europe and Japan, will soon see negative rates, as early as next year. Six months ago, that was unthinkable.
On Wednesday, Fed Chairman, Jerome Powell, gave a virtual speech at the Peterson Institute of International Economics. He said, “The FOMC committee’s view on negative rates really has not changed. That is not something that we’re looking at.” But he did not rule out that option in the future if the economy worsened. The bond market thinks it will.
He also warned that “the recovery may take some time to gather momentum, and the passage of time can turn liquidity problems into solvency problems.” That is Fed-speak for don’t look for a recovery any time soon, and you may see a lot more bankruptcies.
Negative interest rates are considered a tool that has failed the test of time. Both Europe and Japan have tried them, and while negative interest rates have staved off a severe recession up until now, they are a bad choice. The current opinion is that they should be used “when everything else fails.” Unfortunately, that message has not dented the conviction of our real estate speculator-cum-president.
“I disagree with him on one thing now and that’s negative interest rates,” remarked President Trump after Powell’s speech. In Trump’s mind, negative rates are a “gift.” I understand where the president is coming from.
As a real estate magnate, one of the critical variables in any deal is interest rates. How much you can borrow at the lowest rate possible in order to sell sometime in the future at hopefully appreciated prices. While Trump has had a spotty record in doing so, his most successful deals depended on buying at the right price and borrowing at the lowest interest rates.
Trump looks at the U.S. economy in the same way, in my opinion. Even the naivest businessman recognizes that the U.S. economy is not a real estate transaction. In an economy, there are always three or four parties to such a transaction—the lender, seller, borrower, and buyer. If rates are too low the lender loses money. If the sale price is too low, the seller gets hurt. The borrower/buyer may make out but maybe not in the long run. Despite efforts from his cabinet, advisors, etc., Trump just doesn’t get it and he won’t be swayed from his penchant for zero interest rates.
In any case, the bond market believes the economy may be moving into dire straits, which is not the message we are receiving from the White House, nor many analysts on Wall Street. Presently, a debate rages on whether the economy will take on a “V”-shaped recovery, like the stock market, or instead, recover in a less rapid “U”-shaped fashion. In either case, the expectations are that it will recover, that COVID-19 is disappearing, and things will be back to normal by this summer, if we open the economy back up now.
That’s the message from the president, much of the Republican leadership, and their constituency, both on Wall Street, as well as Main Street. Can one blame them? Business owners are terrified with nightmares of imminent bankruptcy. Most will do anything, including risking the health and possible lives of their employees, to open back up.
Politically, Trump’s standings in the polls are dropping dramatically. Few, if any, presidents have been re-elected when unemployment and the economy are this weak. Come to think of it, “weak” would be a great leap forward compared to the reality.
So, who has it wrong? The stock jockeys, or the bond vigilantes? Maybe they both do. We could see virus cases drop but continue to linger with flare-ups in the fall. That would stretch out the “U” recovery, but it wouldn’t knock us back into another Great Depression. The stock market, on the other hand, could come back down to earth at the same time, reflecting a more reasonable valuation of the economic circumstances.
In any case, last week, I warned readers to expect a correction “this week or next.” It appears that the stock slide has begun. Throughout the remainder of May and into June, the markets could be unsettled with a bias to the downside. The decline, however, won’t be in a straight line. Let’s target 2,660 on the S&P 500 Index as a first stop. That would bring us to around a 9.5 % decline from the recent highs. While that plays out, that should give investors enough time to ascertain whether the economic re-opening exercise that is underway will be a success or failure. Stay tuned.