@theMarket: Has the Fed Waited Too Long?

"Be careful what you wish for" is an often-used quote. In the case of the financial markets, all year long, traders and the Fed wished for a slower economy, less employment, and therefore a decline in inflation. Now that we have it, the markets don't like it.

 

Earlier in the week, the bulls could not have asked for a more dovish Federal Open Market Committee meeting. While the central bank maintained its higher-for-longer stance, it hinted that September could see the first of several interest rate cuts. Jerome Powell, the chairman of the Federal Reserve Bank, said it will depend on economic data over the next several weeks. "If that test is met, a reduction in our policy rate could be on the table as soon as the next meeting in September."

 

But it would not only be the inflation data that the Fed would be eyeing. The Fed has now shifted to a more balanced approach between maintaining employment and reducing inflation. Powell admitted that at this point cutting interest rates "too late or too little could unduly weaken economic activity and employment."

 

In the meantime, other central banks have already cut interest rates. The Bank of England was the latest bank to reduce their interest rates on Thursday. Both traders and the Fed, have been watching the labor market for clues to the health of the economy.

 

As Powell explained in the FOMC Q&A session on Wednesday, "I don't think of the labor market in its current state as a likely source of significant inflationary pressures. So, I would not like to see material further cooling in the labor market." However, that is exactly what occurred one day after that meeting.

 

On Thursday, last week's report on jobless claims rose to an 11-month high with unemployment benefits filings hitting 249,000, up from 236,000 last week. Those numbers are still small compared to the overall number of employed in the nation, but the trend is not your friend if you are worried about a softening labor market and a hard landing for the economy.

 

It didn't help that on the same day the deteriorating health of the manufacturing sector came under the spotlight. Manufacturing has been weak for months. The sector has been below 50 on the ISM Manufacturing PMI, which is the cut-off between a weakening sector and one that is healthy. The ISM Manufacturing PMI for July showed a decrease to 46.8 versus 48.8 expected. The market interpreted that data point as a sure sign of a weakening economy.

 

Coupled with the jobless claims data and the ISM numbers, Friday's non-farm payroll data was also a disappointment. Job gains registered a mere 114,000, which was below the consensus of 175,000 expected. The unemployment rate also spiked higher to 4.3 percent from 4.1 percent in June. Wage growth also slowed to 3.6 percent from 3.9 percent year-over-year.

 

Suddenly, in the space of three days, the mood of the markets swung from Wednesday's "The Fed has it covered" with their wait-and-see data stance, to the "Fed has waited too long to cut."

 

Fed critics have argued for some time that when you begin to see the labor market roll over, it is already too late to avoid a sharp decline in economic activity. Many economists agree with the Sahm Rule, named after a former Fed economist, Claudia Sahm, who believed that when the unemployment rate rises 50 basis points from its low of the past year a recession is almost always underway. That has now happened.

 

The debt market took note by driving the yield on the benchmark 10-year, U.S. Treasury bond below 4 percent first the first time since February. Traders are not only convinced that the Fed will need to cut interest rates soon but are also worried that when they do, it will be too little, too late to stave off a recession. That triggered a rush for safety. Between the drop in yields and the poor manufacturing data, the stock market swooned giving back all of the gains for the week and then some.

 

If you recall my writing a month or so ago, I acknowledged at the time that everything was coming up roses as far as the economic environment was concerned. Nonetheless, my Spidey sense told me to be cautious in July and expect a sell-off. I have found that intuition is sometimes as valuable as a spreadsheet full of data in this business.

 

As for this weeks' recession scare, I come down on the side that one or two data points stacked up against a lot of numbers indicating continued growth in the economy fails to convince me we are heading for a hard landing. But if one needed a trigger to take profits, a recession scare is a good excuse.

 

In any case, the volatility in July has now rolled over into August. This week, stocks have gyrated in both directions, gaining and losing more than 1-2 percent a day in all three averages as well as in the small-cap arena. It is the kind of action one normally sees at the bottom and top of markets and indicates a change in the trend.

 

The S&P 500 Index racked up a 5 percent loss, while the NASDAQ lost double that in July. So far this month, which is usually a bad month for the markets anyway (as is September), we are extending those losses.

 

Last week, I wrote that the pullback was not yet over, but I did expect a bounce, and we got that last week. I believe there may be a bit more downside ahead with a total decline of as much as 7 percent from the high on the S&P 500. We may see that by the end of this week, and I may be conservative. A full 10 percent correction would not surprise me either.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.