Jun 10/15 – The party is over Luke

2015-06-10 8am EDT  |  #Bianco #bonds #economy #Fed #Gundlach #Japan #JGB #Nikkei #Yellen

The Fed was pushed another step closer to their first interest rate hike since 2006 with yesterday’s release of the JOLTS employment figures. Economists had forecast 5044 job openings, but the number blew off the barn doors at 5376. The prior month was also revised from 4994 up to 5109.

Janet Yellen previously indicated she watches the JOLTS release closely, so this scorching hot number definitely increases the chance of a rate hike. It is yet another piece of ammo for the “ZIRP was suppose to be an emergency rate and that time has long passed” crowd.

Slowly, more and more traders are concluding the Fed will hike rates this September. Although many of the macro economic indicators are sputtering along, the employment picture is improving at a dramatic pace. There is simply no way to paint this in a negative light. There is absolutely no weakness in the labour market. Don’t listen to the ZeroHedge types who pick the one part of the report that is not improving as quickly. Of course there are aspects of the labour environment that could be better. But the important thing to realize is that the direction of change is unambiguously positive.

Yesterday the market’s pricing of the number of months until the first hike plunged to a new three year low.

The market has priced in a certain December hike, and the only question is whether September will be discounted shortly.

But here is where it gets interesting. This is probably the closest we have been to a rate hike since 2008, right? Wrong. Let’s step back and look at this indicator in a little longer time frame.

In 2009 and 2010 the market had priced in 5.5 months until the first rate hike on a few occasions. At that time the market believed the economy would snap back quickly and the Fed would be forced to raise rates. Yet during this period, the Fed was busy trying to talk down expectations of a rate hike. In fact, not only didn’t they raise rates, but instead expanded their QE programs.

Contrast that to today. The market is skeptical of the Fed’s willingness to raise rates, and refuses to price in tightening even as the Fed consistently warns about the need for higher rates.

The Reformed Broker Josh Brown summed it up nicely in one of his tweets:

Josh is reading the signs and coming to the conclusion the Fed will tighten sooner rather than later.

Yet for every Josh, there is a Jeff Gundlach and Jim Bianco out there.

In a recent CNBC interview when asked point blank if the Fed would tighten in 2015, they both responded with an emphatic NO! Both guys are shrewd market veterans. I don’t dismiss what they say lightly. It makes sense to understand why they feel this way.

And if I had to sum up the reason for their skepticism, it would probably be rooted in their belief the economy will not be able to achieve a self sustaining momentum. Jeff and Jim would argue the economy will quickly stall the moment the Fed even tries to raise rates. Bridgewater’s Ray Dalio warned about the dangers of raising rates too quickly. He speculated it could be a repeat of the 1937 experience. I think Jim and Jeff are so negative on the economy, they don’t even believe we can get to that point. Have a look at what Jim Bianco said during this same interview:

No one has ever raised rates off of zero. No one has ever ended a quantitative easing program. No one has ever done it using tools like interest on excess reserves and reverse repos. No one has ever tried to target a Fed funds market that doesn’t really exist. And they are going to try to do this where the long bond is demanding they raise rate, and the Fed Funds futures market is demanding they don’t raise rates. So you have the markets giving them confused signals. Everything they are going to try is completely unprecedented good luck.

I researched Jim’s point about no economy ever raising rates off the zero level. I couldn’t find any examples, so I have to assume he is correct. It is interesting to realize we are in completely uncharted waters. Don’t listen to anyone who tells you they know how it will end. No one has a clue.

But I have one observation about the nature of today’s markets. Big macro economic policy shifts used to take days, months and sometimes even a year to be fully priced in. The timeframe for markets to adjust to policy changes has collapsed in our interconnected electronic highly leveraged world. The Swiss National Bank’s decision to abandon their peg to the Euro is a perfect example of this new reality. The market immediately gapped to the new price in a matter of seconds. It was amazing how quickly the new information was discounted.

The Fed is trying to warn the market about the upcoming rate hike, but they are not listening. To some extent the Fed has lost credibility, and many (like Bianco and Gundlach) do not believe they have the guts to follow through with their threats. I have been banging on this drum for a few months, but I will hit it one more time. This loss of creditability will make the actual rate hike way worse than would otherwise be the case

Many wise market watchers are claiming the markets and the economy will handle a Fed rate hike just fine. They root their forecast in previous tightening cycles. Well, I will take the other side of their trade. The world has changed. Yes, I agree the economy will be able to handle higher rates, but the markets – not a chance. When the Fed finally pulls the trigger, all the big money managers like Gundlach who have been betting on the Fed’s timidity will be forced to puke. It will be ugly.

Japan – the Nikkei and JGBs

I am going to leave you with one last, super long term chart. The JGBs had a rough session overnight, and it looks like they might finally be playing catch up to the bond weakness we have seen throughout the rest of the developed world. It is difficult to short them into this weakness, but step back and think about the longer term picture.

I still contend it wouldn’t take much for JGB yields to double in the coming year…

Thanks for reading,

Kevin Muir

the MacroTourist