Hurry up and wait!
Written by: Benjamin Bimson CIMA® / BCJ Financial Group
If you are a 5 year old, you do not like this phrase. If you are the markets, you don’t like it either.
So what are we waiting for? Since last week’s job’s report was such a shocker and very surprising (considering the missed estimates), that end-of-the-year party should be right around the corner! Not so much. After all that hurry, now we wait with great anticipation.
What to do from here? Although we will find out very shortly what the Fed will do this week, the data from last week continues to be helpful. All is not great, but all is also not horrible either, and this makes the Fed’s decision a difficult one.
There are a few things we can look at which we didn’t discuss in last week’s commentary. First off, we have an environment where inflation is stubbornly low, earnings expectations are low, and consumers have certainly become more cautious.
We can get an idea of what the inflation expectation for the market is by looking at the 10-year treasury rates. The following chart looks at government bond yields for 10-year sovereign debt and as you can see the rates are being driven lower and lower.
This makes it extremely challenging for the Fed in their decision. In addition, for the US treasury (top portion of the chart), the yields are much higher than foreign options. This means that if the Fed does raise rates, foreign investors will further be incentivized to purchase US treasuries. This also means the US will pay more nominal rates and get the same expected yield on treasury investments. Furthermore, nominal rates tied to treasury rates (like mortgages) will not go up.
Unfortunately, this affects financial companies and they have a big impact on the S&P 500 Index. As you can see in the following chart, financial prices are anticipating nominal rates, not rising. As a result, the stock prices of the underlying companies are beginning to drop below the 50 day moving average.
This is not in and of itself a reason to think we are headed for trouble, but rather an indication that we will continue to wait as the Fed looks for reasons to raise rates. Like I said, hurry up to wait.
So what else is causing consternation? Historically the dollar has followed oil commodity price in trend, however in the last few months it has broken apart, which is puzzling because the correlation over time has been nearly 1 (meaning nearly perfectly correlated).
This could possibly mean that even if the Fed does raise rates, it would increase the value of the dollar and push inflation downward which is not currently the direction that the Fed wants it to go. The dollar deviation from oil also comes from foreign investors purchasing US dollar dominated debt as a hedge against their own currency on negative yields. This all makes the road ahead quite a challenge for the Fed.
Overall, the economy is not as bad as it was during the beginning of the year, but even though markets have recovered, growth has slowed, and now we are just looking for an indication that things will go up from here. The bottom line is that we need to see PE ratios improve. To do that, corporate earnings must grow, which is hard to in the holding pattern. If the Fed and other central banks work together to keep monetary policy easy, we could see growth in the short term. If the Fed is hard-nosed about raising rates, there could be some selling-off.
However, both of these options have long term consequences. If the Fed keeps easing rates, eventually we have to pay the piper. The longer it goes, the worse the potential pain. If the Fed raises rates now and sticks to their original plan of rate normalization over the near term, it could cause some market turmoil. Again, hurry up and wait!
Nobody enjoys it, but these things are simply not in the control of investors, and policy continues to rule the day.
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