Pavlov’s Dogs Drool Again

Like Mr. Pavlov’s famously conditioned canines, the stock market caught the latest trade news… and the drool came flowing.

All three major indexes were up and away from the opening whistle today. But why?

The president’s senior economics man — Larry Kudlow — held out the choice morsel last evening…

“We’re getting close,” he declared, adding:

“The mood music is pretty good, and that has not always been so in these things.”

That “mood music” primed the salivary glands for action.

But we might remind the gentleman that the mood music was plenty lively last week.

Does he not recall the rumors of imminent truce?

But the notes proved false, clanging rudely off the ears.

The hopeful walked off, entirely out of heart… and sunken.

Why should this instance prove different?

The Boy Who Cried Wolf

“It’s like the boy who cried wolf,” argues Matt Lloyd, chief investment strategist at Advisors Asset Management.

We will stand aloof — arms folded, nose snootily in the air, glowering down from our skeptical perch — until the facts force us down.

But Wall Street’s salivating dogs cannot resist the dangled promise of grub… or the boy’s 116th wolf alert.

Shane Oliver is the chief economist at AMP Capital. From whom:

Markets want to believe that there will be some sort of resolution to this issue, some sort of lasting truce at least, even though the experience of the last 18 months doesn’t give a lot of cause for comfort.

Here are some additional sources of discomfort:

United States industrial production has plunged to its lowest depth since March 2009…

United States freight volume (year over year) runs negative for 11 months straight…

And real gross private domestic investment has gone backward two consecutive quarters.

When will the dogs gag and choke on this gristle?

Growth Projected to Approach Stall Speed

The Atlanta wing of the Federal Reserve gives out its “GDPNow” economic forecast model.

Like a weather forecast of perpetual sun, this GDPNow generally runs to preposterous optimism.

But even it presently warns of weather.

Its latest model projects 0.3% fourth-quarter growth — down from 1.0% just one week prior.

The New York Federal Reserve gives its own forecast by way of its “Nowcast” model.

It presently projects 0.4% fourth-quarter growth. Last week it put out 0.7%.

Meantime, current GDP gutters along at 1.9%. And the International Monetary Fund recently downscaled its 2019 global forecast… to the lowest level since the financial crisis.

Yet — yet — the stock market jets past at record heights.

The Braying Dogs of Wall Street

But look at unemployment, the drooling dogs of Wall Street howl.

Unemployment has sunk to 50-year lows, they will remind you (3.6%). The stratospheric stock market thus sinks authentic roots in rich soil of the real economy.

But as we have noted many and oft… unemployment below 4% is no cause to cheer.

That is because recession always lurks when unemployment sinks below 4%.

United States unemployment slipped beneath 4% last May. It previously slipped beneath 4% in April 2000 — at the peak of the dot-com psychosis.

The economy was sunk in recession one year later.

Prior to 2000, unemployment had previously fallen below 4% in December 1969. The economy entered recession shortly thereafter.

In case you prefer a visual reminder:


Affirms John T. Harvey, professor of economics at Texas Christian University:

Unemployment is often quite low at the start of a recession. From third-quarter 1954 through the start of our last downturn, unemployment averaged 5.77%. In the quarter immediately preceding the recessions over that period, unemployment was 4.1%, 5.1%, 3.6%, 4.8%, 6%, 7.4%, 5.3%, 3.9% and 4.7% — in other words, it had been below average in every instance except for the two recessions in the middle of the oil crisis.

And even in those cases, unemployment had been trending down from where it had been the previous year.

But let us redirect our attention to the stock market as it currently goes…

The Dow Jones ended the day 223 points in green territory. The S&P gained 24. And the Nasdaq?

It gained 62 points today.

But the latest trade rumpus alone does not explain the market’s dizziness…

Point to the Fed

As we have also explained recently:

The Federal Reserve began losing its hold on interest rates in September.

Money market rates jumped to 10% as liquidity went dry.

The New York Federal Reserve has since emptied some $280 billion into money markets.

Portions of that $280 billion have unquestionably funded speculative activity on Wall Street.

Jerome Powell insists these “open market operations” are not quantitative easing.

They merely plug a leak within the financial plumbing.

Money market rates have come down accordingly.

But these operations have expanded the Federal Reserve’s balance sheet… precisely as if they were quantitative easing:


And so we have our greater explanation for the stock market’s beautiful run of late.

Report our friends at Zero Hedge:

[This] explains the dramatic surge in the S&P 500, which has increased every week for the past five, the same period that saw the Fed’s balance sheet grow weekly!

Meantime, the Federal Reserve has now hosed in so much liquidity… it risks losing control of rates on the low side.

A Breach of the Floor

Recall, it “targets” rates within a specific range.

Presently that range runs between 1.50% and 1.75%.

Money market rates spiked to 10% in September. But the Federal Reserve’s heavy soaking collapsed them to 1.55%.

That is, the Federal Reserve has emptied in so much liquidity it risks a breach of the floor.

Why a risk?

Explains Bloomberg:

Actions including the Fed’s recent repo-market liquidity injections and Treasury-bill purchases have pushed the effective fed funds rate down to 1.55%. That’s still within the 1.50–1.75% band where central bankers want it to be, but it’s unusually near the lower boundary. Some are worried it could dip below.

When that rate strays, it tends to signal that the Fed doesn’t have strong control over its main tool for implementing monetary policy, a worrisome prospect for central bankers. It happened in mid-September as fed funds briefly jumped 5 basis points above the upper bound, prompting hundreds of billions of dollars of Fed intervention to get things back under control.

But the Federal Reserve intends to maintain these liquid “open market operations” through 2020’s second quarter.

Might they represent the kerosene that ignites a melt-up in stocks?

More to come…


Brian Maher
Managing editor, The Daily Reckoning

The Daily Reckoning