Will Fed Cuts Help the US Dodge Recession?

Tue, Oct 29, 2019 - 12:42pm

Has the U.S. dodged a recession heading into 2020? Should we be worried about the different stories emerging from the manufacturing and consumer sides of the U.S. economy? On a recent edition of the Financial Sense Newshour Jim Puplava and Chris Preitauer discuss these issues and hear from technician Tom McClellan and Frank Holmes of Global Investors to get their take on market conditions.

See Gold Heading Higher as Currencies Reset, Says Frank Holmes for audio.

A Strong Finish for 2019

McClellan believes 2019 will end on a high note and added that he’s bullish heading into 2020. This prediction fits into where we are within the current presidential cycle. McClellan uses a Presidential Cycle Pattern (see below) which takes data from the S&P 500 and divides it into four-year sections. It then averages these together to determine typical performance and market behavior at every point within a presidential term.

Source: McClellan Financial Publications. Note: Past performance is no guarantee of future results

The third year of a president’s term is typically bullish. The first two years, McClellan explained, are usually spent discovering the realities of what’s wrong and fighting with Congress to get something done. By the second half of a presidential term markets tend to do well, allowing the president to declare victory heading into reelection.

It’s normal for markets move sideways in summer and early fall at this point in the cycle, but McClellan expects a pickup heading into winter. He pointed to strong breadth numbers with advances minus declines strongly favoring bulls. This indicates that liquidity is plentiful, and the Fed is tipping the liquidity scale with another $60 billion.

“There is a lot of money available to lift stocks,” he said. “We just have to get past whatever's worrying everybody at the moment. … Especially when you have a first-term president, it's much more likely that the election year will be an up year. We're seeing confirmation of that in terms of the strong breadth numbers and I expect to see a breakout in the S&P 500 very soon.”

Interest Rates, Bonds and Inflation

McClellan pointed out that the U.S. hasn’t followed a typical Presidential Cycle Pattern in the first two years of Trump’s presidency. The December 2018 decline certainly didn’t follow script, but he believes the market’s back on track.

Interest rates on 10-year Treasury notes spiked to 3.25% in 2018 and they have since fallen to about 1.8%. There is still great demand for long-term Treasury bonds as many retirees rely on these for guaranteed returns. Bond prices are heading even higher as the trade becomes more crowded.

Source: McClellan Financial Publications

Inflation remains subdued, leading some to argue bond yields are too low for the rate of inflation. McClellan expects inflation to begin heading higher over the next 20 years. This follows a 60-year cycle in long-term interest rates (see above), and as he pointed out, we're now 10 years into the ascending phase of this cycle. As a result, he expects to see interest rates climb steadily to about 2040.

“Interest rates have been really low for longer than they should,” McClellan said. “That likely means they have some payback coming. Between now and 2040, I wouldn't want to be a long-term holder of Treasury bonds.”

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Fed Planning More Cuts

The Fed is expected to cut rates again this week and McClellan agrees with the move. If you look at the chart comparing the two-year Treasury note yield to the Fed Funds target rate (see below), the rate is still around a quarter of a point above the two-year yield.

A problem occurs when the two-year yield and the Fed Funds rate are too far apart. If the Fed were to outsource interest rate policy to the two-year note yield, McClellan believes we’d likely see fewer bubbles and more muted recessions and depressions.

Source: Bloomberg, Financial Sense Wealth Management

If the Fed aims to reach a neutral level between the two-year and Fed Funds rate, they’ll need to drop rates by another quarter point. This would keep the Fed from becoming too simulative. They likely headed off a recession by adjusting policy from hawkish to dovish this year.

“The Fed wasn't quick enough, but it was quicker,” McClellan said. “And the reason that they don't have market based people helping them is that they all have very expensive PhDs and economics degrees, and what the market says is different than what they were taught in school. … They don't use the scientific method very much in economics where they test their hypothesis against what actually happens.”

Frank Holmes on Well-Performing Assets

Bonds, stocks and even some commodities are currently doing well. Gold has been up this year, despite a recent pullback. Holmes explained his thoughts on gold and other assets where he sees potential.

It’s important to recognize gold’s strong inverse relationship to real interest rates. To find real interest rates, he suggests looking at five- or 10-year government bonds and subtracting the Consumer Price Index (CPI) number. You’ll get a rate of return that’s either positive or negative and Holmes says this is the real interest rate.

He expects gold to rally following the October sell off. When gold hit its high of $1900, real interest rates for 10-year government bonds in the U.S. hit negative 300 basis points. They then rallied to almost 300 basis points, forcing gold down to roughly $1,000 an ounce.

Following this move, we’ve seen gold turn steadily higher. Now, with negative real interest rates popping up around the world, gold appears to be breaking out again. Despite global growth concerns, copper is likely to do well thanks to increasing demand.

The overall percentage of negative G20 government bonds peaked in August coinciding with high gold prices. Rates have increased slightly, though many are still close to negative. Meanwhile, the price of gold sold off and corrected. Holmes thinks the G20 is completely consumed with their attempts to synchronize interest rates and taxation policy.

The U.S. and China are still in the midst of a trade war, however, there’s also a war on money. This war on cash is at play all around the world, Holmes said, from anti-money laundering laws to increased regulations and higher taxes. This is positive for hard assets. He sees the same repressive policies in place with crypto currencies, which are being suppressed because central banks and governments don’t want to compete with them.

Holmes believes the G20 countries “are trying to stimulate economic growth by saying money is free. That has its inherent flaws, and it makes real assets, from art to gold to real estate, show spectacular performance. If you look back long-term, for the past 20 years, the best performing asset class has been Real Estate Investment Trusts (REITs). Number two is bullion. When we take a look this year, REITs and bullion have done exceptionally well.”

Growing Expectations for Government Policy

Whether it's tuition-free college education, universal basic income, or Medicare for All, the most recent election cycle has shed light on the popularity and implementation of these policies in other countries and has raised questions on how or if they should be implemented in the U.S.

“Many of these ideas come from EU socialist policies that are making their way into the U.K. and the U.S.,” Holmes explained. “This is what really led to Brexit,” he posited. Holmes believes “Brexit is a pushback against this socialist mindset.” He continued, “the battle really is citizens against governments that are looking for taxation to run their big governments.”

Is a Recession Still Possible?

In the Big Picture, Jim and Chris discussed what’s in store for the economy and markets in the coming months. Puplava believes the Fed is likely to cut interest rates this week as global growth has decelerated. Germany appears to be in a recession, Japan is slowing down and the European Central Bank (ECB) is cutting interest rates.

In the U.S., the ISM Manufacturing Index has been in contractionary territory for two consecutive months, indicating a slowdown. Conversely, the Non-Manufacturing Index, representing the U.S. service sector, has been strong. Puplava sees this as an economy that’s split between manufacturing and consumers.

Manufacturing is an area of weakness according to Puplava, as is housing. The U.S. has the lowest mortgage rates in nearly a decade. Additionally, housing starts, existing homes and new homes sales are all slowing down. Housing prices are up more than six percent year-over-year, but inventory is still low even as housing gets more expensive.

Another key drag on the economy is what some are calling “peak auto.” Auto sales peaked in 2017 and fell in 2018. They’ve been down in 2019 and are expected to head lower into 2020 due to rising prices and increasing regulatory requirements.

“We have a bifurcated economy,” Puplava said. “Consumer confidence is up, the stock market is up, wages are up. All of that is good because 70 percent of our economy is based on consumption. On the other side of the coin, what is not looking as good is what we're seeing in manufacturing. … The business side is where we're seeing the weakness.”

Reversal of Fed Policy

The Fed is currently walking back from its hawkish course of the past year. They’re also reversing previous quantitative tightening. The Fed increased its balance sheet last Friday by $7 billion and it also added $77 billion in liquidity into financial markets. The Fed is also going to add roughly $60 billion of T-bill purchases up to the end of the 2020 second quarter.

“What we have going for us now, at least for the stock market, is global liquidity,” Puplava said. "The Fed is injecting liquidity into the financial markets. … They're likely going to cut next week and there’s a high probability they'll end up cutting for the fourth time in December. … A major risk to the market has been removed. Things are looking good on the consumer end, with unemployment and wage increases acting as positives. As long as that remains true, outside a major shock, I don't see a recession.”

To listen to this podcast, see Gold Heading Higher as Currencies Reset, Says Frank Holmes, or for a full archive of past shows, visit our Financial Sense Newshour page.

Written by Ethan D. Mizer

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