Lower Rates Fuel

The 2 biggest factors for corporate earnings are economic growth and ........ interest rates.  Most investors focus on economic growth and usually don't pay much attention to interest rates, because it works more subtly and with a lag.  Also historically, economic growth was more volatile than interest rates, making it a much more important factor in determining stock prices.

However, since 2008, economic growth has been stable, but low. The business cycle has become the business flat line. Economic growth used to be a variable.  Now it is basically a constant.  That is what happens when you have a battle between downward forces of demographics/lack of productivity growth versus upward forces to growth from big tax cuts and deficit spending and a hyper proactive Fed looking to rescue financial markets with a firehose of liquidity at the slightest hint of a slowdown.


Since 2008, other than Fed funds rates, the yield 5+ years out have been erratic.  In 2009, with ZIRP, the 10 year yield was as high as 3.90%.  In 2012, with the same ZIRP, the 10 year yield went downt to 1.40%.  And then up as high as 3.00% in 2013.  And then back down to 1.32% in 2016.  All while Fed funds rate was below 50 bps.

It is no longer economic growth that is most important factor determining stock prices.  It is corporate welfare/regulatory capture and interest rates that are the biggest drivers.  The 2 biggest catalysts for stocks in the last 10 years has been QEs and tax cuts.  Those aren't organic growth factors.  They are policy driven factors that have diminishing returns and limitations.  The Fed cannot buy up all the Treasuries and MBS issued.  Nor can the tax rate go to zero.

With  trillion dollar deficits happening during the peak of an expansion, that tells you all that you need to know about the long term sustainability of current tax rates.  This huge deficit, which puts an upward pressure on interest rates, has to be countered with loose monetary policy to maintain the expansion.  Basically, the US will have to follow Japan and monetize its debt to keep growth where it wants it to be.

The bond market is sensing that the long term sustainable interest rate is much lower than current Fed funds rate given the weakening leading indicators, and the change in Powell's reaction function towards financial markets, specifically, the SPX.  Jerome Powell is now in Bazooka Ben mode.  If stocks goes up, talk dovish.  If stocks stays flat or go down, act dovish, i.e., cut or do QE.

The declining Treasury yields in May due to the above mentioned factors was the fuel that the stock market needed to come back this month, once the weak hands sold.  But a lot of this fuel has been used up, as the 10 year is nearing 2%.

In other words, stocks currently need the 10 year yield at 2.15% to maintain SPX 2880.  Previously in the fall of 2018, stocks could maintain SPX 2880 with a 10 year yield above 3.00%.  It is taking lower and lower interest rates to maintain current stock valuations.  This can't go on forever.  The stock market is the gas guzzling Land Rover.  Lower interest rates are the fuel.  If the Fed doesn't deliver with easy money soon, the stock market will have a panic attack.  Just like December 2018.  I do expect Jerome Powell to deliver the goods, giving the market what it wants, having learned his lesson in December about fighting dovish market expectations.  But he's a bit less predictable than Bernanke, so there is a slim chance he could trigger another rush to the exits for stock traders.

One thing is clear though.  Whatever Powell does in June or July meetings, the financial markets now have him by the balls, at their mercy.  He will have to be their slave, or else.