Two Paths Diverge
Financial Review by Sinclair Noe for 12-02-2015
DOW – 158 = 17,729
SPX – 23 = 2079
NAS – 33 = 5123
10 YR YLD + .03 = 2.18
OIL – 1.67 = 40.1
GOLD – 15.60 = 1054.20
American businesses stepped up hiring last month, led by strong gains in retail, finance and other service industries. Payroll processor ADP says that private companies added 217,000 jobs last month, the most in five months. Service sector firms added 204,000, while manufacturers hired just 6,000. The figures come just two days before the government issues its official jobs report for November. If the Friday jobs report is anywhere close to today’s ADP report, it might lock in a rate hike at the Fed FOMC meeting in two weeks.
The productivity of American businesses was higher in the third quarter than initially reported — but so were labor costs. Newly revised government figures show that productivity rose at a 2.2% annual rate instead of 1.6%. Unit-labor costs were revised higher to show a 1.8% annual increase in the third quarter, and second quarter costs were revised higher. As a result, the year-over-year increase in labor costs climbed to a 3% rate, the highest level in six quarters. Unit-labor costs reflect how much it costs a business to produce one unit of output, such as a refrigerator or a ton of steel.
The Fed published their Beige Book, anecdotes on the economy collected from the 12 Fed districts; the information is published two weeks before FOMC policy meetings. There were no surprises in the report; 9 of the 12 districts report growth, the same as the October report. The economy seems to be growing at a moderate or modest pace. Housing markets improved at a moderate pace. Labor markets are starting to show hints of tightening but we’re not there yet. The conditions in the manufacturing sector were mixed; the strong dollar hurts some areas; low commodity prices hurt some areas, especially the energy sector; but low gas prices were helping consumers. Auto sales were strong. You know this stuff.
Federal Reserve Chair Janet Yellen spoke before the Economic Club in Washington DC; tomorrow she testifies before the Congressional Joint Economic Committee. Today Yellen said the economic data of the past couple of months has been consistent with expectations for an improving labor market and she is confident inflation is headed for the Fed’s target in the medium term. Here’s the key quote from Yellen: “Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.”
If it sounds like Yellen has made up her mind about raising interest rates in 2 weeks, you are correct. The only suspense is her ability to herd the cats in the FOMC to something approaching unanimity. And the markets have priced in a rate hike. The next concern is the pace, duration, and amount of hikes. And the answer is slow and steady, and not over 1% by the end of 2016; again, this is priced into markets. The next concern is how the Fed will go about trimming its massive $4.5 trillion balance sheet and how the Fed can nudge banks to trim their excess reserves without triggering inflation. I posed that question today to Charles Plosser, the former President of the Philly Fed, and the answer was very slowly and cautiously because we are in uncharted territory.
Eurozone inflation held steady at a lower-than-expected 0.1% in November, giving further encouragement to ECB president Mario Draghi to pump up the central bank’s bond buying program tomorrow during a policy-setting meeting. In March, the ECB launched a more than €1trillion-euro stimulus plan running through September 2016 in order to snap a long period of low or negative inflation in the region, but given recent economic figures, that program will likely get a boost.
Greek Prime Minister Alexis Tsipras is hopeful that capital controls imposed at the height of the country’s debt crisis in July can be lifted in the first half of 2016. Addressing a conference of the Hellenic-American Chamber of Commerce, Tsipras said his government had taken the first steps to address non-performing loans and recapitalize banks so they could start lending again to the economy.
In the US we are starting to see hints of inflation, the labor market has shown steady, solid improvement, and economic growth is up. So, while you might argue against a rate hike from the Fed, really the idea is not particularly controversial. Now, juxtapose that against the Eurozone; ECB President Mario Draghi talks about the need for more and more stimulative policy. Tomorrow we’ll see if he can get the idea past the Germans or if the weakness of the southern tier defines the day; if not tomorrow, then he’ll push the idea of rate cuts and more bond buying to a future policy meeting. No matter the timetable, the paths for the Fed and the ECB are laid out, and they diverge. What happens in this scenario?
Well we can look to 1994, when the Fed tightened and Germany was cutting rates; remember, this was before the Euro Union. Back then, the dollar slipped; not really a surprise. History is not on the dollar’s side. In the last couple of decades, the dollar index has fallen every time the Federal Reserve has begun a cycle of interest rate hikes. The dollar just hit a 12 year high, so you might wonder if it is a bit overbought.
Certainly the thinking is that a rate hike would strengthen the dollar against its weaker global counterparts, and it might, for a while but the dollar would be susceptible to pullbacks on any sign of weakness or any sign the Fed is tightening too much or too fast. Even with modest and controlled tightening we might expect to see economic recovery in the Eurozone weighing on the dollar, not in the next month or two but over the course of the next year.
The bet on a strong dollar is one of the most crowded trades in the market today, despite the precedent of 1994. Meanwhile, bets on the euro are the most bearish ever. The US won’t stand by for long if the dollar appreciates significantly and its international competitiveness deteriorates substantially. Companies are already reporting earnings pressures due to the rising dollar, and some are even calling it a currency war, and demanding a more forceful response.
Next, watch the debt markets and especially the yield curve, that’s the spread between the 2-year yield and the 10-year yield. Rising interest rates and short-term debt yields could choke growth, while stable or falling long-term yields suggests investors see lower growth and looser monetary policy further ahead. Some think the yield curve could invert, with the yield on the 2-year dropping below the yield on the 10-year note. An inversion is a pretty sure sign of recession, but we’re still a long way from an inverted curve.
Also keep an eye on the spread between US Treasuries and German Bunds; this interest rate differential between risk free bonds has widened, but it can only be stretched so far. And watch the spread between the dollar and the currencies of emerging market countries. Sharp movements in interest rates and exchange rates can cause volatility in other markets. If it gets severe, it can create shocks.
And keep in mind that even if the ECB and the Fed diverge on interest rate policy, this shouldn’t shock anybody, because it would just be an extension of the existing divergence on quantitative policy. The Fed has already ended its bond buying binge known as Quantitative Easing Part 3, or 4, or whatever; just as the ECB started up its own QE. We already have quantitative divergence. Monetary policy divergence is not that different.
The instinctive reaction of many is that this widening gap between central bank policies must lead to a stronger dollar, but clearly it is not that simple. Different economies, different paths. We have some history to guide us, but it still feels like uncharted territory.
U.S. House and Senate negotiators have reached an agreement on a five-year highway bill that would also reauthorize the Export-Import Bank. The $305 billion bill would be partly financed by use of Fed surplus funds and a cut in the dividends received by commercial banks that own the Fed. House Speaker Paul Ryan predicts the bill will enjoy “good majority support” when it comes up for a full vote.
Crude oil supplies rose by 1.6 million barrels in the week ended November 27, according to the American Petroleum Institute, way above expectations for a decline of 1.2 million barrels. The more closely watched Energy Information Administration report came out later in the afternoon and it showed a buildup of crude supplies and a deepening global glut. Oil prices dipped below $40 a barrel for the first time since August. The nation’s commercial stockpiles of crude oil, gasoline, diesel and other fuels last week soared above 1.3 billion barrels, a fresh record, according to the Energy Information Administration. Crude-oil stockpiles alone rose for the 10th week in a row, bucking expectations for a decline. OPEC is meeting in Vienna on Friday and there is talk of production cuts to support prices, but for now it looks like the world’s producers are pumping like crazy.
And finally, late news coming in of another mass shooting, this time in San Bernardino. The latest, unofficial tally is 14 dead and 14 injured. A manhunt is underway for three shooters; the suspects were heavily armed and possibly wearing body armor, and a bomb squad was on the scene, trying to defuse what was believed to be an explosive device. It seems like we hear these stories all the time these days. Whatever we are doing, it isn’t working.