“Fasten your seatbelts, it’s going to be a bumpy night.” – Margo Channing from All About Eve
Back in late spring of 2013, the Fed was making news with expectations that their asset purchases known as quantitative easing would be tapered back. The market’s reaction to this move was swift and ugly, which collectively became known as the Taper Tantrum when assets across the board all sold off in unison. Last Friday was a bit of deja vu as the market had a similar reaction to a very strong jobs report showing non-farm payrolls increasing by 295,000 in the month of February which was about 60,000 better than the consensus expectation. The increase in jobs dropped the unemployment rate down to 5.5% from 5.7% in January.
The market’s reaction to the strong jobs’ report was not pretty. Stocks sold off abruptly and finished the day down almost a percent and a half as measured by the S&P 500 and as of today have now erased all their gains for 2015. Within the broader market, higher yielding, defensive sectors such as utilities and REITs were each down over 3%, a little over two times the drop in the broader market index (As a side note, at the beginning of March, our MarketVANE model gave us a signal to sell all of our diversified REIT ETF and trim back half of our exposure to utilities…better to be lucky than good sometimes). The bond market’s reaction to the news was equally ugly as holders of the 10 year US Treasury note lost a little over a full percentage point on the day. To put this kind of one day move into perspective, the yield on the 10 year Treasury as of the close on Thursday stood at 2.11%, so Friday’s move essentially erased close to 6 months’ worth of interest payments. In other markets, oil, gold, and commodities in general all sold off sharply as well.
About the only investment that was green on the day was the US dollar, which gained close to a percent and a half. Dollar strength has been the theme over the past several quarters as it has pushed through levels not seen in over a decade.
The dollar strength is primarily due to divergent monetary policies being pursued here in the US versus Europe and Japan. (As a side note, we have benefited from the USD strength through our short position in the Japanese Yen vs. the US dollar). In the US the Fed has been tightening their monetary policy by ending its quantitative easing program and beginning discussions on raising short-term interest rates. Contrast this with the Bank of Japan which has been pursuing a massive QE program since April of 2013, which was recently expanded in October of last year, or the European Central Bank which recently announced a QE program of their own. The market’s anticipation of all the bond buying from central banks has driven yields down to absolutely ludicrous levels in Europe and Japan. In fact, one third of all sovereign debt in Europe now trades at negative interest rates. If that doesn’t scream deflation, I don’t know what does. The spread between the 10-year US Treasury Note and the 10-year German Bund are now at historically high levels.
Oddly enough, a strong dollar acts as its own form of monetary tightening. A strong dollar puts downward pressure on US inflation and slows down exports as US goods and services become more expensive to foreign buyers. This is why some have stipulated that the one way move in the dollar over the past 9 months may be all the monetary tightening the Fed wants to see at this point. That being said, after Friday’s job numbers, the across the board sell-off in asset prices indicated a Fed rate hike would be forthcoming. We can look at the pricing of Fed Funds futures to determine the probability of a rate hike which investors are baking into the price. Before Friday’s report, the futures were pricing in a 48% chance of a 25 bps rate hike at the Fed’s June meeting. After the report, the probability jumped up to 70% in June and an 82% chance of a 25 bps hike by the September meeting.
The problem the Fed now faces is do they risk losing credibility by continuing their über-dovish stance and forgo raising rates under the guise of a strong US dollar or do they fall in-line with the markets expectations and start hiking rates this summer? A raise in interest rates will only further feed the strength in the US dollar as well the divergence in bond yields here in the US versus other developed economies.
Strong job growth and a drop in the unemployment rate are indicative of a growing economy. Under “normal” market environments these signs should be bullish for assets traditionally tied to economic growth like stocks and to some extent commodities. But today’s market environment is far from normal. At no point in history has the US ever had real GDP hovering around 2.5% with unemployment below 6%, and short-term interest rates at zero all at the same time. The Fed understands this “mixed bag” dynamic, which is why they have continued to err on the side of being too dovish rather than derail the economy with premature tightening. If they chose to raise rates this summer, the question will simply become whether the US economy is strong enough to withstand rate hikes in the face of a deflationary pressures from a stronger currency and sluggish economic growth in other developed countries. It all remains to be seen, but if Friday’s reaction to a potential Fed rate hike is any indication of just how Fed dependent asset prices have become, then investors should fasten their seatbelts as the next several quarters could be a bumpy ride to say the least.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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