Recent Developments and the Outlook for the Markets

The recent developments regarding Fed policy, trade negotiations, Brexit and global growth have clouded the outlook for the stock market.  Fed policy is a positive, while the others are not.  One way to cut through the these divergent developments is to view the markets from an optimal control perspective.  This perspective means that the major markets -- stocks, Treasuries and dollar -- behave in ways that work toward achieving the Fed's goals (2-3% real GDP Growth and 2% inflation), unless a market is dominated by a factor specific to itself.  If specific factors dominate one or other market, the remaining markets have to "work harder" to achieve the Fed's goals.  As a result, the implication for the stock market could depend in part on the behavior of the two other major markets -- Treasuries and the dollar -- as well as the Fed's goals.

Currently, the Treasury market and dollar are working at cross-purposes relative to the Fed's goals.   Lower long-term yields are a positive for growth and inflation.  But, the stronger dollar is a negative.  While this means that stocks have a bigger burden to help achieve the Fed's goals, Powell's ambiguous defense of the 25 BP cut last week raised doubts that financial markets need to do much more, on balance, if anything, to achieve the goals.  This suggests the stock market may have overshot on the upside in its rally leading up to the July 30-31 FOMC Meeting.  But, a pullback is likely to be temporary.

Treasury and FX Market Behavior
The Treasury and FX markets have a clearer relationship to the recent developments.  Slow growth, with attendant negative interest rates, and Brexit uncertainty have prompted outflows of money from Europe to the US.  This has led to a stronger dollar and lower long-term yields.  The breakdown of US/China negotiations with last week's announcement of additional tariffs on China also has had the effect of boosting the dollar.  The additional tariffs reduce the expected trade deficit, which is a positive for the dollar.  These market moves have divergent implications for the Fed's goals.  Lower long-term yields should help achieve the Fed's goals.  But, a stronger dollar works against them.

Treasury Yields and the Economy
Lower long-term yields should help spur US economic growth both by lowering the cost of capital for business and household borrowing and by boosting the present value of future corporate earnings and thus consumption through higher stock prices.  The positive impact on economic growth is mitigated, however, to the extent that investment/household spending is unresponsive to the lower rates.  This might be the case because interest rates are already low or because demand is moving away from traditionally interest-sensitive purchases.  For example, news reports say that Millenials have been shifting to renting rather than buying a home and have pulled back from purchasing motor vehicles.  If lower yields have little traction in boosting US economic activity, it is conceivable that yields can fall more sharply than most people think.  In the limit, perhaps, they can move down to the negative rates seen in Europe, due to arbitrage.

Dollar and the Economy
The stronger dollar not only holds down import prices but makes exports less competitive globally -- both contrary to the Fed's goals.  While the tariffs will provide a one-off boost to inflation as they are passed through to consumers, this boost could be more than offset by the broader pulling down of import prices from the stronger dollar.   A stronger dollar also works against attempts by workers to boost their wage rates.  Foreign labor is even more competitive because of the stronger dollar except in those industries protected by tariffs.  Curiously, some Democratic presidential candidates have criticized Trump's tariffs while calling for stronger labor unions to boost wages.  Tariffs, however, may be the only way for unions to regain their strength. 

Does the Stock Market Have to Rally?
So, with a stronger dollar working against the Fed's goals and lower yields possibly having little effect on the US economy, the stock market will be the main channel for monetary policy.  Stocks will have to rally over time for the Fed' monetary policy to be effective in achieving its goals.   This does not mean that stocks cannot pull back temporarily, even by a significant amount.  And, this risks being the case now in the seasonally weak August.  Powell's ambivalent defense of the Fed's 25 BP rate cut throws doubt on the near-term need to push the economy harder.  A pullback could conceivably continue into September as a way to force the Fed to ease again that month.  But, this should be followed by a rally, particularly if the Fed takes a more aggressive stance toward its goals than it did last week.

 Market Dynamics
The dynamics of these potential market moves could be self-reinforcing.  A stock market rally could attract more foreign monies pouring into the US, which would raise the dollar further, holding down inflation and keeping longer-term yields low.  This dynamic would last until stronger US economic growth pushes up inflation.  One non-market factor that could help boost growth is additional fiscal stimulus.  So, the latest budget agreement might have been well-timed.  But, it needs to be analyzed in some detail to see how much effective stimulus it contains.