Stock Market Has a Terrible Wednesday

On Wednesday, the stock market had its worst down day since September 2016. Many headlines claimed the stock market fell because of political controversies involving the firing of FBI director James Comey, but I’m skeptical of that conclusion because the market has ignored this story for days. In Monday’sarticle, I predicted that the VIX would end its streak of closing under 11 this week and that the streak of days where the S&P 500 had a less than 0.5% move would also end this week. This isn’t because I had special knowledge of the political investigation. It’s because the market had been too quiet given the weakness in economic data as measured by the Citi Surprise Index. It’s like water building up pressure against a wall; eventually the wall will come down and the floodgates will burst open.

The chart below shows that the iPath S&P 500 VIX Short-Term Futures exchange-traded note had record volume on Wednesday. The S&P 500 fell about 1.8% and the VIX finally soared. My point isn’t that the Trump investigations don’t matter at all. It’s that the market was bound to fall at some point given the weak data. The biggest question the market has regarding this story is whether it slows down Trump’s agenda of getting tax reform and healthcare reform passed. I don’t think it will slow it down because healthcare reform depends on how negotiations among Republican Senators go. The White House’s budget plan will be announced next week. While I don’t this latest controversy will slow down the legislative agenda, that’s not saying that it will pass easily. The reason the process has been so slow is because GOP members have ideological differences. How those differences are resolved will determine what gets done.

As you can see from the chart below, the chance of a rate hike in June fell on Wednesday. The odds rebounded on Thursday back to 73.8%. The fact that the chances of a rate hike fell so much supports my claim that economic weakness caused this selloff. If the decline was caused by only political risk, the chance of a rate hike wouldn’t move. As much as the media focuses on political issues, economic activity isn’t affected by it. For example, in Q1 optimism ran high after the election, yet GDP growth was 0.7%. In Q2 we may have a reversal where pessimism runs high, yet GDP growth is above 2%. While I don’t claim that the Citi Surprise Index is the ultimate arbiter of economic activity because it was strong in Q1 even though GDP was weak, I do understand that if economic surveys disappoint, the stock market usually falls. The fall to a -37.50 reading along with hard data weakness was behind the selloff on Wednesday.

Taking the discussion back to monetary policy, if I were to look at the economic reports and ignore what the Fed has said, I wouldn’t expect a rate hike. You can see the U.S. Surprise Index crashing, the weak Q1 GDP report, and the decelerating CPI. However, I do acknowledge that the Fed has a tough decision. The labor market appears to be tightening, so wage inflation can start spiking quickly. The Fed would want to get ahead of that spike. The reason this situation is tougher than usual is because we’re at the end of the business cycle, yet the economy is barely growing. If the Fed hikes rates 3 times this year, without tax cuts being passed, the economy could fall into a recession. If the Fed doesn’t hike rates, wage inflation could get out of hand. At that point, the Fed would have to react quickly.

Cleveland Fed President Loretta Mester spoke on Thursday. She said that the Fed should hike rates in June and start to shrink the balance sheet this year to avoid falling behind the curve. Her supporting evidence was the strong labor market and that inflation is near the Fed’s 2% target. I agree with the assertion that inflation is near the 2% target, but it looks to be decelerating along with hourly wage growth and oil prices. Even though monetary policy shouldn’t be made based off the price of oil, it’s still worth paying close attention to how OPEC’s decision next week affects the price. A further decline would impact inflation. At the same time, it appears the Fed no longer cares about near term inflation because it thinks the tight labor market will boost inflation in the intermediate term.

There are many puts and takes to analyze with the Fed’s decision, but the bottom line is the Fed will raise rates at the June meeting. The consensus on the balance sheet is for the Fed to start aggressively shrinking it in mid-2018. I don’t think Mester’s comments on shrinking the balance sheet later this year are inconsistent with expectations. I think she’s trying to get the market ready for the June statement which will lay out the details of the balance sheet unwind. Up until then, much of the forecasts made by investors are speculation. The June meeting will be the first one where the Fed’s decision interest rates won’t be the headline story. The Fed might make a decision on the balance sheet reduction which goes against expectations causing a knee-jerk reaction in the markets.

Conclusion

Wednesday saw a burst in volatility as the market finally reacted to the weak economic data. The lull in volatility meant the market was due for some action. The political drama probably wasn’t the cause of the selloff, in my opinion, because stocks have been ignoring politics for the past few months and this won’t alter the agenda for tax cuts.

Loretta Mester made it clear to investors that the Fed will hike rates in June and unwind the balance sheet at the end of the year. These decisions are tough because of fiscal policy uncertainty and because wage inflation hasn’t come despite the 4.4% unemployment rate. Wage inflation could spur GDP growth since the consumer is responsible for 2/3rds of it. That would be the perfect case for the Fed to hike rates. Since we’re not there yet, the Fed’s policy relies on hope, which is risky.

1 Comment

  • Wallace Mackay

    May 19, 2017

    Love your analysis and wisdom. Good stuff. Thanks.