Today, I want to start by looking at some basic facts:
1. The Federal Reserve cut interest rates.
2. The Fed's mandate is to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."
Given those two simple facts, logic tells us that the Fed must have cut rates because unemployment is rising, prices are rising too rapidly, or long-term rates are deterring investment and capital purchases.
But that's not why the Fed cut...
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According to Chairman Jerome Powell, the Fed cut to insure against downside risks from weak global growth; offset risks of trade policy uncertainty; and to promote a faster return of inflation to a symmetric 2% objective.
Weak global growth and policy uncertainty are related. That refers to the trade war. Threatening to impose tariffs, an increasingly common tactic of the current administration, is creating uncertainty. The actual imposition of those tariffs is slowing growth.
The Houston Chronicle summarized the problem nicely:
President Donald Trump's decision to impose tariffs on an additional $300 billion in Chinese goods sent oil markets into a nosedive Thursday, delivering a setback to an already slumping energy industry and a potential blow to a Houston economy still linked to the fortunes of the oil and gas sector.
Oil prices plunged 8 percent in a little more than hour following the president's tweet that he would impose a 10 percent tariff of the remaining Chinese products not covered by earlier rounds of tariffs as of Sept. 1."
With last week's rate cut, the Fed is trying to look ahead. This is now officially a dangerous situation.
Why Things Could Get Ugly
Simply put, the Fed is preparing for an economic slowdown and believes a trade war is among the biggest economic risks. Traders agree with the Fed, as the chart below shows.
Notice that the market had fully recovered after Powell stumbled through his press conference last Wednesday. Powell had stunned traders when he said this rate cut might be the only cut for this year. Traders were convinced there would be multiple cuts, and Powell's comment sent the Dow Jones Industrial Average down more than 200 points in a few minutes.
Later in the press conference, he corrected that impression and implied additional cuts will follow. By Thursday morning, the Dow had completely recovered those losses before Trump announced new tariffs.
This news sent stock prices down and proved Powell was right. The greatest threat the economy faces now is a trade war. The next chart shows that traders expect the Fed to lose this battle. It's a chart of the Treasury yield curve and suggests a recession is likely.
The yield curve is a graph showing current interest rates for various periods. Normally, the graph slopes upward because longer-term bonds carry higher interest rates. For example, a 15-year mortgage has a lower interest rate than a 30-year mortgage because there is less risk over 15 years.
In the chart above, the curve is inverted. Yields on five-year Treasuries are lower than the yield on six-month Treasuries. This is what we see ahead of a recession.
One reason the yield curve inverts is because businesses are worried about the risk of a recession. They are unwilling to borrow to fund new investments and this results in lower interest rates for longer term loans. Lower interest rates are a sign of reduced demand and are, in effect, an effort by lenders to encourage borrowers.
The Fed cut rates trying to push the lower end of the yield curve down and hopefully create demand for longer-term loans. So far, that hasn't worked. That's why the yield curve is inverted.
Action To Take
This all provides a clear message for investors in the stock market. It's important to keep the potential bear market in mind. Declines associated with recessions average more than 35%. That's a lot of risk, and that's the level of risk in stocks right now. Managing risk will be important in the next few weeks. This can be done by focusing on the short term and by ensuring new positions provide a margin of safety.