Apr 07/15 – “Nah Nah Nah – I can’t hear you”
2015-04-07 9am EDT | #bonds #curve #earnings #stocks
Tomorrow earnings season kicks off with Alcoa starting the parade of first quarter earnings releases. Although analysts have been tempering down their growth estimates due to the especially cold winter on the East coast of North America and the strong US dollar, my suspicion is that they are still in for a surprise.
The rate at which the US dollar appreciated over the past six months is virtually unprecedented. There is no way that analysts have gotten ahead of those adjustments. The surprise will not be that the currency strength affected US businesses less than expected, but instead analysts will scramble to explain why stock earnings are not meeting their optimist estimates.
The especially cold and snowy winter on the North American East coast will give them a convenient excuse, but it will be tough to reason away the kind of weakness we are about to encounter.
During the past couple of quarters the global economy has experienced an enormous hiccup. Global growth has plummeted and shown no signs of bouncing.
When you combine the weak global economy with the terrible winter weather, and most importantly the almost obscenely strong US dollar, you have monster headwinds for US corporate profitability.
And it’s not like the analysts are pessimistic in their earnings growth estimates. Even though profits as a percentage of GDP are at all time highs, analysts are forecasting approximately 10% continued earnings growth in the coming years.
Over the past few months the markets have been able to stick their fingers in their ears and scream out “nah nah nah – I can’t hear you!” to all the problems that are piling up at their feet. But cold hard numbers can’t lie. I suspect that this earnings season will force the stock market to deal with the uncomfortable realities that are plaguing the global economy. I am starting a core short position in US stock index futures that I will hold for the coming weeks. Although I am actually quite bullish on the economy, I think the stock market has some big ugly surprises in store for it.
I hold a dramatically out of consensus view that the US yield curve will steepen in the coming years even as the Federal Reserve tightens policy (I guess I should say even if the Federal Reserve tightens policy). Although traditionally as the economy improves, and the Fed tightens, the curve has flattened, I don’t think this tightening cycle will look like past cycles.
Given the gargantuan amount of debt in the system, the economy has become especially sensitive to rate increases. The slightest increase in rates will cause the economy to quickly grind to a halt. The past few months is the perfect example. Even the threat of higher rates has sent the US dollar soaring to the point where the economy has stalled enough to cause the Federal Reserve to put on hold their tightening plans. NY Fed President William Dudley admitted as much yesterday:
In a New Jersey speech, Dudley cited staff analysis of the dollar's effect: "[A]n appreciation of this magnitude [nearly 15 percent since mid-2014] would, all else equal, reduce real GDP growth by about 0.6 percentage point over this year." Such an impact is likely to reduce the Fed’s confidence that the economy is ready to endure raising interest rates as early as June.
The Federal Reserve (and most other Central Banks) are trapped. They have encouraged so much debt to be created that they cannot afford to allow that debt to be destroyed otherwise the economy will quickly fall into a vicious self reinforcing negative feedback loop. They must therefore above all else leave real rates at negative levels.
This will mean that the Fed will only raise rates kicking and screaming. They will by necessity be forced to continually be behind the curve. They will only raise rates when it becomes so painfully obvious that the market has already done the raising for them.
As the market realizes the Fed will never again be willing to get ahead of the curve, the long end will sell off hard. This will of course cause financial conditions to tighten, which will only encourage the Fed to be even less aggressive with their tightening. Eventually the Fed will lose control of the long end and that will be the end game.
In the coming years I could envision a point where the Fed has short rates set at the nominally low level of 1% or 2%, yet the long bond is trading at 6% or 8%. My suspicion is that the curve will eventually become super steep. Although we saw some wide levels in the aftermath of the credit crisis, before this is all through, we are going to see new modern day highs in curve steepness.
So far though, my theory is a dud. The curve has been flattening like a pancake for the past year. In fact, you could argue that my theory has been just flat out wrong. The long end of the curve has been especially well behaved. In fact, as the Fed has attempted to set up the market for rate hikes, investors have bid up the long end of the curve.
Yet the reality is that Fed has recently delayed their first rate hike for the very reasons that I forecast – the economy is showing no ability to be able to weather a hike. And the curve has recently responded by steepening for the first time in a while.
I think that this might be the first step in the market figuring out that the Fed will always be behind the curve.