Markets Are Feeling Fine About a Fed Pause

(Bloomberg Opinion) -- We’ve been underestimating the stock market all along. There’s been a strong case to be made that this year’s rally — in the face of a slowing economy and stagnant earnings growth — was due solely to the Federal Reserve’s dovish pivot back in January and subsequent interest-rate cuts. But on Wednesday, the S&P 500 Index rose to a new record even though the central bank strongly hinted it sees no reason to ease monetary policy further.

The biggest indication that the Fed feels it’s time to pause after reducing its target rate for overnight loans between banks three times since July was the absence in its statement of the phrase that it would “act as appropriate to sustain the expansion.” Those words have been a way of signaling that markets can expect lower rates. So why not a stronger reaction after that phrase was taken out? There are two ways to interpret this: One is that investors know a lot could happen between now and the next monetary policy meeting Dec. 10-11 that could persuade the Fed to lower rates again. The second is that the Fed has provided just the right amount of “insurance” to avoid recession anytime soon. Yes, growth has slowed, but the latest data doesn’t suggest a material worsening in conditions, especially among consumers, which account for more than two-thirds of the economy. That was evident in the government’s report on gross domestic product for the third quarter that was released earlier in the day. It showed the economy expanded at a 1.9% annualized rate, topping forecasts in a Bloomberg survey that called for 1.6% growth. Consumer spending came in at a 2.9% rate, exceeding projections for a 2.6% increase and more than offsetting the biggest drop in business spending since 2015.

To be sure, there are still a lot of concerns about equities, starting with valuations. The S&P 500 is now trading at an expensive 20 times earnings, the most since stocks began their steep plunge in last year’s fourth quarter. And Wall Street strategists on average seem reluctant to boost their market forecasts with earnings estimates for this quarter and 2020 starting to come down. The median estimate of about 25 Wall Street strategists surveyed by Bloomberg earlier this month was for the S&P 500 to end the year at 3,000. It finished Wednesday at 3,046.77.

BOND TRADERS ARE HAPPY
Perhaps an even bigger surprise than stocks was the reaction in the bond market. Although U.S. Treasuries came off their highs for the day, they still ended up with a gain, which means yields fell. Those on benchmark 10-year notes fell 6 basis points, or 0.06 percentage point, to 1.78%. To be sure, those yields had advanced from around 1.53% earlier this month in a sign that bond traders had expected the Fed to signal that this rate cut would be the last unless the economy got noticeably worse. Markets will find out soon enough whether the Fed was right to signal that a pause is warranted; on Friday, the government releases its unemployment report for October and the Institute for Supply Management releases its monthly manufacturing index. The jobs report is forecast to show that businesses added 85,000 workers this month, down from 136,000 in September and one of the weakest readings in years. The ISM index is expected to rise to 49 from 47.8, but that would still leave it below the critical 50 level that marks the dividing line between contraction and expansion. “The uneven nature of the data will keep the discussion of a December rate cut at the Fed fruitful at the very least,” Lindsey Piegza, the chief economist at Stifel Nicolaus in Chicago, wrote in a research note. There was one small sign from the bond market that perhaps the Fed is making a mistake. That’s seen in the yield curve, where the gap between two- and 10-year rates narrowed by about 3 basis points to 17 basis points in a traditional sign that traders anticipate lower growth.

CANADA’S CURRENCY WAR
Bank of Canada Governor Stephen Poloz, one of the few major central bankers in the world to resist the push toward easier monetary policy, did what was expected on Wednesday and acknowledged that he’s considering the merits of joining other countries in lowering interest rates. What was unexpected, though, was an explicit mention of the strength of Canada’s dollar in the central bank’s official statement, suggesting to some that policy makers see a weaker currency as key to a stronger economy. It’s rare to see the Bank of Canada single out the so-called loonie. As such, traders pushed the currency lower, making it the biggest loser among its developed-market peers. The Bloomberg Correlated-Weighted Index that tracks the Canada dollar against nine other major currencies fell as much as 0.94% in its biggest drop in a year. Measured by that index, the loonie had advanced about 7.50% this year through Tuesday to its strongest since early 2015, making the gain the biggest of the group. The lower currency is a relief, given that Canada’s economy isn’t exactly going gangbusters. Economists expect growth to slow to 1.5% over the next two years, slightly below potential. The weakness in the currency may not last long. With the Fed lowering its lending benchmark to a range of 1.50% to 1.75%, Canada now has the highest policy rate in the developed world at 1.75%, which could lure foreign capital and therefore prop up the loonie.

CHILE’S TRAVAILS 
Markets are discovering that national protests are hard to stop once they gain momentum. That was made clear in Hong Kong, and now it’s happening in Chile. The nation’s benchmark stock index tumbled more than 3% on Wednesday, bringing its slide since Oct. 18 to about 9% as the biggest social unrest in a generation forced the government to cancel next month’s APEC summit in Santiago. That’s where President Donald Trump was expected to sign a preliminary trade accord with China. (The White House insisted that it would continue to press to finalize the “phase-one” agreement in coming weeks.) Chile’s peso was also a big loser, weakening as much as 3%. The nation’s economy has a reputation for being one of the more stable ones in Latin America in recent years, so in some ways, what’s happening in Chile is a bit unexpected. Any number of strategists have described the weakness in Chilean stocks, bonds and the currency as “overdone.” After all, the protests have their roots in a relatively minor 3% increase in subway fares. Even so, there are now calls for an overhaul of the country’s free-market economy that has produced what Bloomberg News describes as both vast wealth and vast inequality. The Chamber of Commerce warned that retail sales in Santiago probably fell more than 10% in October because of the unrest.

SOME DEFICITS STILL MATTER
South Africa is providing a fresh reminder that state-controlled enterprises are hardly the most efficient way of delivering services to an economy. The nation’s currency tumbled the most in the world on Thursday, and its government bonds also fell after the Finance Ministry released a statement showing that the country’s predominant electricity supplier, Eskom Holdings SOC Ltd., will receive 138 billion rand ($9.4 billion) in bailouts through March 2022, or 10 billion rand more than previously allocated. And that may not be all. The statement warned that extra support may be needed if plans to turn the utility around are delayed. That means South Africa’s government debt will top 70% of gross domestic product in the next three years, compared with a previous projection of 60.2% in 2024, according to Bloomberg News’s Dana El Baltaji and Selcuk Gokoluk. The issue for markets is that South Africa may be in imminent jeopardy of losing its final investment-grade credit rating from one of the three major credit ratings firms. Moody’s Investors Service is due to review South Africa’s Baa3 rating – the lowest investment grade - this week.

TEA LEAVES
The U.S. Commerce Department’s first look at third-quarter gross domestic product released on Wednesday reinforced the notion that consumers are buttressing the economy. Consumer spending, the biggest part of the economy, increased at a 2.9% annualized rate and exceeded projections for a 2.6% rise. For businesses, though, nonresidential fixed investment fell the most since late 2015. What we don’t know is whether consumer spending was level throughout the quarter or started off strong before fading at the end. The answer may come Thursday, when the government reports on personal income and spending for September. Spending is forecast to have risen 0.3% last month after increasing 0.1% in August and 0.5% in July. There’s one big reason to be cautious: Two weeks ago the Commerce Department said retail sales for September fell 0.3% in September from the prior month, shocking economists who had forecast a 0.3% increase. 

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To contact the editor responsible for this story: Beth Williams at bewilliams@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Robert Burgess is an editor for Bloomberg Opinion. He is the former global executive editor in charge of financial markets for Bloomberg News. As managing editor, he led the company’s news coverage of credit markets during the global financial crisis.

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