Nov 09/15 – Two camps, and I don’t belong to either of them
2015-11-09 11am EDT | #Fed #inflation #stocks #unemployment #Yellen
It’s tough to argue Friday’s employment number was anything less than stellar. Change in private sector payrolls was 271k versus 185k expected. The unemployment rate stuck at 5.0%. But most importantly, average earnings rose to 2.5% versus a forecasted 2.3%.
The Federal Reserve has been itching for a reason to raise rates off the zero bound for the last six months, and barring any major change in the economic or market environment, they will most likely do so at the December 16th FOMC meeting.
Some might disagree with that prediction. Many market pundits believe the Federal Reserve doesn’t have the stomach to actually raise rates, but I disagree. The much hoped for uptick in inflation appears to be finally taking root. It has been a long time in coming, but the Fed’s warnings that monetary policy acts with a long lag seems to be kicking in.
Have a look at this chart of various CPI inflation gauges ex-energy:
There can be no denying that ex-energy, inflation is ticking up.
And now with Friday’s recent barn burner average hourly increase, workers finally seem to be reaping some of the benefits of the sixth year of economic expansion.
It is ironic that just as many economic pundits were predicting the death of the Phillip’s Curve, we get the much hoped for rise. The following typical chart, which argued the stubbornly low employment to population ratio made the Phillip’s Curve irrelevant, was all too common in analysts’ outbox over the past year.
But in reality, we should have been listening to Nordea’s Martin Enlund (a great economist/strategist who should be on everyone’s must follow list – @enlundm), who last month was urging patience before throwing out the Phillip’s Curve.
If you look closely at Martin’s chart you will notice he has lagged the wage increase by four quarters. By doing so, the current Phillip’s Curve is not broken, but simply takes a year before labour tightening shows up in wage increases. I believe the highlighted point is last month’s reading, but the recent hot wage inflation number was forecasted perfectly by Martin’s model.
There has been a large contingent on the FOMC who have been uncomfortable with the Zero Interest Rate Policy (ZIRP). I like to call them the “zero was an emergency rate, and the emergency is long past” crowd. With the recent inflation and hourly wage increases, it will be almost impossible for Yellen and the rest of the doves to hold off any interest rate increases. Rates are going up in December, and the only question is what does this mean for the market.
Although I am confident the Federal Reserve will raise rates, I don’t have anywhere near the same level of conviction of how this will affect the market and the economy. I am not sure anyone really knows. There are lots of pundits who claim to know, but given the world’s Central Banks’ massive science experiment, I am not sure anyone has any true insights into what will happen.
I am watching closely for signals from the market. I could make the case we are about to collapse in a deflationary vicious circle. But at the same time, I am aware of the massive amount of monetary fuel Central Banks have been heaping on the world’s economy over the past six years. If that fuel has finally been lit, then a 25 basis point rise not going to stop it.
Instead of telling you what I think will happen, I am going to instead outline the two camp’s arguments, and let you decide.
Let’s start with the doomsdayers first.
This crowd thinks a Fed tightening into the global economic slowdown will push the world economy off a 2008 style deflationary cliff. Higher US rates are causing global financial liquidity to contract, resulting in a higher US dollar as worldwide debt gets destroyed.
These pessimists (and I cannot deny leaning towards this persuasion) believe the US economy cannot handle higher rates and a higher US dollar. The staggering about of debt makes the absence of stimulus already a dangerous proposition. But then when you combine the over 200% rally in the US stock market with a Federal Reserve that is trying to raise rates while the rest of the world is sinking into a deflationary funk, you have the recipe for disaster.
On Friday I watched an interview with one of these doomsdayers who recommended buying US treasury bonds and shorting corporate credit. He was adamant the Federal Reserve would push the US economy into a credit crisis.
I am not sure about this recommendation. Corporate credit spreads seem to offer some real value versus equities. If I were negative, I think shorting equities is a much better risk reward. But I do believe that if this doomdayer’s prediction comes to fruition and corporate credit spreads widen in the coming week or two, then the chances for a large accident in the global markets will increase exponentially.
But what about the other camp?
Why are they convinced the Federal Reserve’s hiking of rates will not derail this market rally nor crush the economy? For this group, the zero interest rate policy has been more hindrance than help. They argue the zero rates are penalizing savers, distorting capital allocation, and creating more uncertainty that only causes real investment to be delayed. These optimists also believe the start of previous rate rising cycles have not been the death knell for other bull markets, so why should this time be different? They welcome the rise in rates as they believe the economy will be able to once again grow without the perversion of a zero interest rate.
The funny thing about these two camps? They are each absolutely convinced they are right.
I don’t know who is correct. I am more willing to take a wait and see approach. Although I am nervous about the gargantuan amount of debt, I am equally nervous about the even stupider amount of monetary stimulus that has been applied over the past six years.
Ever since the 2008 credit crisis, each time the Federal Reserve has believed the fire has finally been lit, the flame has petered out. There is a very good chance that this rate rise will accomplish the same result.
Yet, a little part of me is worried when everyone is convinced inflation will never rear its ugly head, the monster comes out of the closet.
Over the last year we have experienced a brutal amount of deflation in the commodity arena. But what if the decline in energy has masked a pickup in overall inflation? What if the simple stabilization of the price of oil will be enough for inflation to once again start ticking up? And what if the velocity of money has stopped going down, and might even reverse course?
I know these are crazy sounding ideas, but the market has a habit of surprising the consensus at the most inopportune time. Although I am a somewhat of a bear on risk assets, I am keeping an open mind.
Last week I saw a good friend who manages a lot of equity money. He had recently started reading my market pieces. He had some kind words to say, but left it with “you’re a little too bearish for me…” As I drove home, I thought about why I was so bearish. Although I could articulate some really good reasons why I hated the market, there was a part of me that had to admit, as stupid as it all seems, it could still get a lot more stupider.
And what really worries me is my bearishness is by no means an outlier opinion. Most hedge fund guys are leaning to the short side. Have a look at the speculative positioning in the S&P 500 futures contract:
The specs have been getting short for the past six months, and don’t seem at all phazed by the recent rally.
We are approaching an important point for both the market, and the economy. Very shortly we will know if the rally of the past six years can stand on its own two feet without the help of the Federal Reserve. Everyone seems to have an opinion, and although I have a guess, I don’t see the point in gambling.
We are really stretched to the upside on a short term basis, so a pause or a small correction would be in order. But from there, I don’t know what to think. Instead of predicting, I think a much better plan of attack is to wait and let the market tell you which way we are headed. I know that is a mopey technician like comment. I get it. But there are times when it makes sense to bet big, and there are times to wait and see. I think this is one of those times where it makes more sense to keep the powder dry.
The risks on either side are much higher than most market participants believe.
Thanks for reading,