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Investors Hoping for Bad News to Get Good Interest Rates are Making a Mistake

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Investors Hoping for Bad News to Get Good Interest Rates are Making a Mistake

By John McDonald

As the U.S. economy continues to post lackluster metrics like relatively low jobs reports, investors and markets continue to cheer these reports. Why? Because the concept that “bad news is now good news” because weaker economic indicators might force the Federal Reserve to lower interest rates has fully seized the market mentality. However, not everyone is on board.

“The expectation that easing central bank policy can offset weaker data is at odds with both a broad swath of historical data and basic monetary theory,” writes Andrew Sheets, global strategist at Morgan Stanley.

Sheets began his arguments against the “bad is good” theory by observing, “There are many ways to define the periods when central bank easing faced off against weaker economic data.” He restricted this particular examination to times when the Fed reduced interest rates and the unemployment rates were “either stagnant or worsening.” The result, he said, were that the S&P 500 posted above-average returns only 38 percent of those times, “a win rate that, if it were for a baseball team, would put it near the bottom of the current major league standings.”

However, he went on, the statistical “win column” is only one thing to consider. Another is that monetary policy works on a lag, meaning that lowering interest rates as a rapid-response mechanism actually invalidates data about whether or not that action was effective. For example, if it takes tax cuts roughly 12 months to take effect and in the interim, the Fed cuts interest rates, which move strengthened the economy? “By the same token, the Fed hike in December, (seven months ago) may still be working its way through the system,” Sheets wrote.

He added weaker economic data can hurt investor confidence, and central-bank actions are not intended to actually eliminate swings in the business cycle, just “dampen” them. When we damage the integrity of our data by interfering with it too often and too soon, that can create trouble because investors then lose confidence in market behavior altogether. For example, after the most recent Fed meeting, which many investors interpreted as making a “promise” to lower rates in July 2019, the stock market soared. However, many experts believe this could be the precursor to the beginning of a bear market.

Christopher Wood, head of global equity strategy at Jefferies, responded to the market highs with a note to clients reading, in part: “[The Greed & Fear Report] does not trust the U.S. stock market at this level. Nor should investors.”

Wood cited oil prices as one key indicator many investors may overlook since the price of oil is not presently considered, as he put it, “severely out of whack.” If oil prices surge above the $100 level, however, Treasury bond prices could plummet while their yields rise. Ultimately, Wood said, this could cause many investors to sell of stocks in large volumes, collapsing the market.

“This has every chance of happening” thanks to current trade policies revolving around a ban on Iranian oil exports, Wood said.

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