Powell Risks Egg on His Face After Sounding Sanguine on Stocks
(Bloomberg) -- Former Federal Reserve Chairman Ben Bernanke infamously told lawmakers in March 2007 that the sub-prime mortgage crisis would likely be “contained” only to rue those words later when it erupted into the worst recession since the Great Depression.
Now the question is whether Jerome Powell, the current central-bank chief, will eventually experience the same sort of egg-on-your-face moment after telling Congress earlier this month that “nothing really is flashing red” in financial markets.
Recent sudden, swift declines in the prices of Facebook Inc. and Twitter Inc. shares suggest it doesn’t take much to open up air pockets in markets with stretched valuations. The risk is that such zones of distress could spread as the Fed and other major central banks withdraw liquidity from the global economy.
“We have a very fragile situation after 10 years of very, very low interest rates,” Harvard University professor Martin Feldstein said in an email.
U.S. stocks sold off on Monday as investors dumped shares of the phalanx of technology companies that had recently been the darlings of the market. The Nasdaq Composite Index sank 1.4 percent as the gauge posted its biggest three-day loss since March.
Powell and his Fed colleagues are widely expected to hold interest rates steady at a two-day policy making meeting that begins on Tuesday. In June, they raised their target range for the federal funds rate for the second time this year, to 1.75 percent to 2 percent, and penciled in two additional, quarter-percentage-point increases for the second half of 2018.
In delivering the Fed’s semi-annual report to Congress earlier this month, Powell used a new word to describe the risks to financial stability: “normal.” Corporate leverage is a “little bit” high but banks are well-capitalized and household finances aren’t stretched. And while many financial asset prices are elevated, “I wouldn’t use the bubble word,” said the Fed chief, who took the institution’s helm in February.
Feldstein, who is a president emeritus of the National Bureau of Economic Research, isn’t so shy. He argues that it’s too late for the Fed to avoid an asset bubble as equity prices have risen far above their historical trend.
He wants the central bank to raise rates to 4 percent by the end of next year. While that would run the risk of bursting the asset bubble earlier than otherwise, it would give the Fed more firepower to fight the recession Feldstein sees on the horizon.
David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates Inc., said in a July 30 note that recent earnings misses by Facebook and other technology companies remind him of something similar happening just before the Nasdaq peaked in 2000 and the economy fell into a recession the year after.
The International Monetary Fund warned in April that an extended period of low interest rates had led to a build-up of “medium-term vulnerabilities” in the world’s financial system that could come to the fore as central banks normalize monetary policy.
“The road ahead may well turn out to be bumpy,” Tobias Adrian, director of the IMF’s monetary and capital markets department, told reporters on April 18.
That may already be occurring. The markets are on course to suffer more big unexpected swings in asset prices this year than at any time since 2008, the height of the financial crisis, according to research by Morgan Stanley strategist Andrew Sheets and his colleagues in London.
“Large moves are happening more often,” they wrote in a July 22 report to clients.
They said a variety of forces were at work, including commercial banks limiting their market making and a tightening of monetary policy.
And there’s likely more of that to come from the world’s major central banks. Former Fed official Roberto Perli sees them shifting to quantitative tightening in 2019 as the combined balance sheets of the monetary authorities in the U.S., China, Japan and the euro zone shrink after years of expansion.
However, the Cornerstone Macro LLC partner told clients in a July 27 video that the Standard & Poor’s 500 stock index will continue to appreciate next year as corporate profits rise further. “Earnings are more important than the balance sheet” of the central banks, he said.
Profits have been super-charged by big cuts in corporate taxes pushed through by President Donald Trump and congressional Republicans last year. Operating earnings in the second quarter were up more than 20 percent from a year earlier for S&P 500 companies that have so far reported their results for the period.
The tax cuts have also helped lift economic growth, with gross domestic product expanding at a 4.1 percent annual clip in the second quarter, its best performance since 2014.
The economy, though, is likely to slow in the second half of the year as the Fed’s past rate increases -- and the rise in bond yields that they’ve engendered -- begin to bite, said Jim Paulsen, chief investment strategist for Leuthold Weeden Capital Management LLC.
“I suspect we’re going to hit an air pocket” for stocks in the second half as economic growth slackens while corporate cost pressures, inflation and interest rates rise, he said, though he doesn’t see a recession in the offing.
Still, that’s a toxic combination that could well prove to be a test for the Fed and its new chairman.
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