Another Trump Tax Cut and the Fed’s Trilemma
Recently President Trump told the media he is working on another tax cut that will further lower the corporate income tax rate and provide a middle-class tax cut. The timing of President Trump’s announcement is spot on with my view that the previous tax cut would have a six-month life expectancy before the economy resumed its deceleration. While President Trump is beginning to sell his next fiscal stimulus package, the Fed is finding itself caught in its own trap.
The Tax Cut and Jobs Act of 2017 did little to cut taxes for the families who need it the most. Current data shows the wealthiest one-percent of our country were the largest beneficiaries of the tax cut. The main reason the wealthy benefited is because the corporate tax rate fell from 35% to 21%. Treasury Secretary Mnuchin pleaded with CEO’s to use the tax cut to reinvest in the economy and to provide wage increases, but the data shows most of the money was plowed into corporate share buybacks to boost executive compensation. President Trump’s latest proposal will take the corporate tax rate down to 20%, which will likely go towards buying more of their stock back.
Since taking office, President Trump has been rather outspoken about how he has helped drive the stock market higher. While it’s rather unusual for a President to routinely comment about the stock market, it’s become acceptable because the stock market has become the U.S. economy. When the Federal Reserve continued pushing asset prices higher through Quantitative Easing 1-3, the stock market detached from reality somewhere back in 2015.
Historically our stock market reflects economic output, which is how real wealth is created. Starting in 2015, the stock market detached itself from industrial production and durable goods orders, which stock prices have historically followed for decades.
Data provided by the Federal Reserve clearly shows that when stock prices rise, spending increases and when stock prices fall, spending decreases. There is definitely a correlation between wealth and spending, which was proven during the tech bubble of the 1990’s. The problem is the Trump Administration is trying to pump stock prices to keep the economy growing while the Federal Reserve is facing an impossible task of dealing with a trilemma of its own creation.
The Federal Reserve is trying to raise the Federal Funds rate to control price-inflation and trying to increase the value of the dollar to keep foreign investors buying our debt, all while hoping to keep asset prices higher, specifically the stock market, to keep the economy growing. The problem for the Fed is they can only achieve two of the three at any one time.
The Fed needs to increase the Federal Funds rate to slow the rate of “inflation”, or price-inflation, and to give themselves the ability to lower interest rates during the next recession. Raising the Federal Funds rate drains liquidity, or dollars, from the economy, which tends to increase the value of the dollar. The reason the stock market stops rising when interest rates rise is because as interest rates rise, investors sell risk assets, or stocks, for a fixed rate of return. To illustrate my point, if interest rates were 7%, very few people would bother owning stocks. Therefore, asset prices cannot continue rising as interest rates rise.
The Trump Administration wants a weaker dollar to turn our economy into an export-driven economy, but the Federal Reserve wants a strong dollar. The Fed understands our biggest export is dollars, which are recycled back to the U.S. to purchase our debt. If the dollar remains strong, then foreign investors are happy to fund our deficits. A strong dollar cuts into corporate profit margins and reduces exports.
Boosting asset prices is probably the easiest of the three to accomplish because the Fed could initiate additional rounds of Quantitative Easing to boost asset prices. Quantitative Easing leads to lower short-term interest rates and eventually a weaker dollar. Again, the best the Fed can hope for is two of the three. This is why the Trump Administration wants another round of tax cuts – it is a form of “stealth” Quantitative Easing.
The Federal Reserve has indicated they will raise the Federal Funds rate two more times this year and three or more times next year. Even if the Fed stopped raising the Federal Funds rate, they are still selling off their balance sheet. In July, the Fed’s balance sheet unwind will increase to $40 billion per month and increase to $50 billion per month in October. Every $60 billion the Fed sells of their balance sheet is an equivalent to a 0.25% increase in the Federal Funds rate. By year’s end, the Fed will have sold off $270 billion of U.S. Treasury bonds and Mortgage-Backed Securities. This will have the effect of 4.5 rate hikes or the equivalent of a 1.125% increase in the Federal Funds rate.
Rising short-term interest rates and a stronger dollar, assuming the dollar continues to rise, will lead to lower asset prices. The purpose of Quantitative Easing was to increase asset prices by boosting bank excess reserves, so Quantitative Tightening should cause asset prices to fall. As the Fed continues to tighten monetary policy and reduce bank excess reserves, stock prices should fall. The reason the major stock indices are all below their all-time highs this year is due to the Fed tightening monetary policy. Again, the problem has become the stock market is the public’s barometer of the economy.
With the economy now driven by stock prices, the Trump Administration needs to find a way to continue pumping the stock market as the Fed continues to tighten monetary policy. According to the Federal Reserve Act of 1937, the Fed does not have the tools or ability to print money. The Federal government does not have the ability to print money either, but it does have the ability to deficit spend.
The reason the Trump Administration needs to push through another tax cut is to keep the stock market higher. Politically this could be to keep the Republican’s in power after the mid-term elections. Economically this could be because the recent tax cut only had a six-month impact. From a trade dispute perspective, another tax cut may be needed to fend off China’s recent move to devalue their currency. Regardless of the reason why, with the U.S. economy dependent on stock prices, any drop in stock prices will lead to a deceleration in economic growth. Between the upcoming elections, trade disputes, and the persistently weak economic growth, there is too much at stake.
It’s interesting someone within the Trump Administration realizes the stock market has become the economy, but what is disconcerting is that nobody seems to understand the power of the unwinding of the Federal Reserve’s balance sheet. In the first quarter, corporations spent approximately $200 billion on stock buyback programs and the Fed drained an equivalent of $120 billion from the economy. Despite $200 billion being pumped into the stock market, the S&P 500 and Dow Jones Industrial Average (DJIA) peaked in January.
Corporate share buybacks are expected to exceed $200 billion in the second quarter, while the Fed will drain $150 billion from the economy. The S&P 500 and DJIA have made a couple of attempts at trying to regain their highs but seem to have lost their momentum. The Nasdaq-100 and Russell 2000 peaked in June and are also showing signs of losing momentum.
The fact that record amounts of money are pouring into the stock market are unable to drive the major stock indices to new all-time highs, proves that asset prices, which includes stocks, are a function of the monetary base. As the Fed reduces the monetary base by raising rates and unwinding their balance sheet, asset prices must fall.
Even though the Trump Administration is pumping stock prices through a “stealth” Quantitative Easing program in the form of corporate tax cuts, the Fed is undermining the entire plan. In the second half of this year, corporations are expected to pump over $500 billion into share buyback programs and the Fed is expected to drain $490 billion from the economy.
There’s little doubt who will win – the Fed will push the economy into the next recession despite how much money is pumped into stocks. Given how aggressive the Fed will be in the second half of the year, I expect we’ll be seeing a recession sooner than later. In addition, regardless of whether or not another tax cut is approved, we will experience another recession because the Fed is focused on raising the Federal Funds rate and boosting the value the dollar, which will lead to lower asset prices and an economic deceleration.
Q&A with Steve – Your Questions Answered
- What happened to the stock market on Monday?
Today goes to the Bull’s who drove the market back up after it gapped down in overnight trading. Foreign markets are starting to slide into Bear market territory, which can drive U.S. stock indices down in overnight trading. Volumes remain low as large traders tend to leave early on holiday weeks. The DJIA remains below its 200-day moving average, which is bearish until proven otherwise.
Treasury yields rose after falling in overnight trading. Financial stocks are hanging on the edge of a cliff and when they fall, so will bond yields. From a technical perspective, Treasury bonds are looking to confirm their upward trending moving averages, which is a positive sign.
Gold – July is the season for gold. Physical gold prices are falling along with sentiment, which is a good signal. When other people are selling, it’s usually a good time to buy. I have been watching the $1,246-48/oz level, which was breached today. The next level I’m watching is $1,238/oz. If prices fail at $1,238/oz, I expect prices to fall to $1,200-15/oz. At some point, gold will bottom and begin moving higher, which will bring the mining stocks with it. That’s what I’m looking for.
The USDA crop reports for last week looked good, but with a massive heat wave and low precipitation hitting the growing region, I can’t imagine crops won’t take damage. Sentiment is in the toilet, so nobody is interested in agricultural commodities right now. Usually, that is a positive sign. China has been devaluing their currency which is driving up US export prices, but the Trump Administration is fully aware that crop prices are too low, and they are looking to take action. Time will tell.
- What happened to the stock market on Tuesday?
The major U.S. indices started their day higher and closed lower, which is a sign that either the Bulls are running out of gas or the Bears are starting to get aggressive. Either way, the DJIA has now made seven consecutive closes below its 200-day moving average, which remains a Bearish signal. The S&P 500 tried to push above its 50-day moving average but closed below. Only tech stocks and small-caps remain above their major moving averages.
Interest rates fell again as money continues to flow into bonds on signs of weaker global growth. Momentum is about to trigger our buy-in.
Physical gold bounced off $1,238/oz which is now the lower end of my target range (thank you Peter Brandt) which sent gold mining stocks higher. Chartists are saying this bounce in gold is short lived and should see gold closer to $1,200/oz. I’ve even seen some suggesting gold will drop by 40%. We’ll see. For the moment we just need to see if this is indeed a bottom or just a pause for the next leg down.
Agricultural commodities have been flat for the past few days. I’m hearing traders say this is a low-risk opportunity to buy commodities given how low the price is.
- What happened to the stock market on Wednesday?
All U.S. markets are closed for Independence Day.
- What happened to the stock market on Thursday?
Over the July 4th holiday, Bank of America Merrill Lynch published a report from their trade desk showing that the main buyer of U.S. equities has been corporations buying their stock back. They noted retail investors and hedge-fund managers have not been buying lately. Market cycles eventually end when they run out of buyers.
Sellers came in early, but the day belonged to the buyers. The June Nonfarm payrolls report comes out tomorrow and the first tariffs against China go into effect.
U.S. Treasuries were flat on the day but reports from the Fed show that banks are back buying Treasuries. This is a good sign.
Physical gold bounced slightly off $1,238/oz, which was the bottom end of the range I am looking at. Over the holiday I saw several charts from charting experts showing the bottom of the range is closer to $1,200/oz. If the dollar continues to rally, it supports a further drop in gold. The gold miners appear to be overreacting to this move and following the equity market higher.
The heat wave hitting the growing region is expected to get worse over the next couple of weeks. I will be following the crop progress reports to see what the impact is.
- What happened to the stock market on Friday?
The Bulls punched through the resistance level that has kept stocks in check for the past week after the “strong” June Nonfarm Payrolls report. The third quarter blackout period for stock buybacks should be coming up and with corporations as the last main buyer of stocks, I expect stock prices to fall before buybacks resume.
I remain rather impressed both the U.S. and Chinese stock market completely ignored the risk of an escalating trade war.
The bond market didn’t have the same reaction to the payroll report as yields fell. The bond market is telling the world that the stock market is wrong and that the economy is more likely to decelerate going forward.
Banks are back buying Treasuries which is putting a floor on bond prices. With bonds once again acting as a safe haven, I am comfortable taking an equity position at the bottom of the next move down in stocks.
Agricultural commodities are setting a bottom despite the newly enacted tariffs.
Physical gold made a small bounce but doesn’t appear to be attracting buyers. The gold miners jumped the gun and I expect them to pull back if gold resumes its move down. Silver miners didn’t confirm the move by the gold miners. If gold doesn’t hold the $1,238/oz level, its next move will be to $1,200/oz.