Don’t Fight the Fed

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By Joseph Cafariello

Monday, July 7th, 2014

U.S. investors woke up last Thursday morning to some bright and cheery news: the higher-than-expected 288,000 new non-farm jobs created in June clobbered the estimate of 218,000, with the unemployment rate falling to 6.1%, beating its estimate of 6.3%.

The strong data could have serious implications for the U.S. Federal Reserves monetary policies.

The stellar jobs report hits the Fed right between the eyes on how good labor-market conditions out there truly are, exclaimed Chris Rupkey, chief financial economist for Bank of Tokyo-Mitsubishi UFJ in New York.

The inexorable decline in the unemployment rate, alongside firming core PCE inflation, is dramatically reducing the degree to which the Fed is missing on its mandate, Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York, wrote to his clients.

Last weeks numbers show the Feds plan for spurring job growth and stoking inflation up to healthy levels is finally working. The Fed is reaching its mark.

For this reason, many economists have increased their expectation of higher interest rates sooner than the Fed had been indicating.

If the recent trend in the labor market continues, the next FOMC interest-rate projections should be even higher, Roberto Perli, a partner at Cornerstone Macro LP in Washington, informed his clients. The odds that the Fed will lift rates off of zero sooner than the market expects are increasing.

Where the U.S. central bank had been alluding to interest rate hikes beginning around late 2015 or early 2016, the whisper on the street now is for hikes to begin several months sooner.

While Feroli moved his expectation for the first rate raise to the third quarter of 2015, PIMCO CEO Bill Gross opines that this report suggests that the risks are weighted more toward the second quarter than the third.

For his part, Rick Rieder, BlackRock Inc.s CIO for Fundamental Fixed Income, is even more optimistic, expecting the first rate hike in the first quarter, explaining that the Fed will move faster than people think because the data is extraordinarily compelling.

It would seem, then, that lower than expected for longer than expected is no longer the course for interest rates.

So far, the doves at the Fed have continued to preach a very slow path to normalization, Stephen Stanley, chief economist at Pierpont Securities LLC, contrasts the Feds official stance. This approach should now be considered under fire.

Some are even warning of hits to the Feds credibility if it does not move soon. If the Fed does not adjust its guidance, forewarned John Ryding, chief economist at RDQ Economics in New York and a former economist at the New York Fed, it will make a mockery of the notion of data-dependent policy.

That is quite the list of experts going on the record in favor of interest rate hikes sooner than later. But the markets dont seem to be agreeing with them. From equities to bonds, the markets still seem to be expecting low interest rates for a considerable period of time, which is what the Fed has been saying for over a year since talk of stimulus tapering first started to circulate back in May of last year. The markets are expecting the Fed to keep its promise.

The Markets Arent Swayed

Despite such a strong employment report raising expectations of faster Fed action, equities pushed higher all day Thursday, with the Dow Jones Industrial Average setting another milestone as it closed above 17,000 points for the first time in its history, while the broader market S&P 500 index also closed at a new all-time high of 1,985.

Normally, you might expect some profit taking heading into a long weekend to lock in some impressive gains of 8.5% on the S&P just from the first six months of the year alone. So far there has been no sell in May and go away, no buy the rumor and sell the news, and no lets take what we can get and run. Investors seem to be sticking around for more.

And not just equity investors. Bondholders seem to be just as doggedly put as well. After the 10-year Treasury retreated on the release of last weeks jobs data, lifting its yield to 2.70% (its highest level in two months), investors found the yield irresistible and ploughed back in, pushing the yield back down to 2.65% at the top of its recent range. There was penetration of the upper band of resistance, but there was no follow-through.

In fact, as noted in the graph of the 10-year Treasury yield below, the first half of this year has seen the benchmark bonds yield steadily falling lower and lower.

Its first range from 2.60% to 2.80% (blue) gave way in late April to an even lower range from 2.50% to 2.67% (green). And as of last week, we still cant break out of it not even on the back of such strong employment data.

Source: BigCharts.com

Who To Listen To?

Weve heard what the economists are telling us. But what are the markets telling us?

Simply stated, equities and bonds are still betting on interest rates remaining lower for longer.

While the general consensus among economists is for the Feds benchmark interest rate to finish 2015 near 1.13% and to end 2016 near 2.5%, Bloomberg reports that the implied yields on federal funds futures contracts traded on the CME Group Inc. exchange foretell the funds rate will be 0.78 percent by the end of next year and 1.81 percent by December 2016.

Although interest rate futures are indeed signaling higher rates, the market is not projecting them to be as high nor as soon as many expect.

Why? What could be blocking the Feds path toward rate normalization? Arent there enough green lights signaling the Fed to move ahead with rate increases?

While there are some green lights, such as strong job creation averaging 200,000 new jobs each month for almost three full years and slightly higher consumer prices in food, gas, and housing, the biggest signal light of all is still stuck on red: wages.

Its actually the wage number that is critical, Gross clarified. The jobs [number] takes second seat.

Remember that all we are getting in the way of new jobs are jobs that were recently lost. So the economy isnt really breaking new ground; it is merely reclaiming old ground that was once held before.

As for higher prices, these arent really signaling that the Fed has finished its job either. The slightly higher prices are being fuelled by slightly more people working. But they are not being fuelled by higher wages.

Wages are still stagnant, and until they start to rise, higher consumer prices still stop climbing. After all, if people cant afford higher prices, prices will stabilize.

This is what the Federal Reserve seems to be anticipating. The Fed knows the recent rise in consumer prices has come from more people working and more paychecks being spent. But the amount of the paychecks has not increased all that much not enough to keep consumer prices steadily rising.

The Fed expects inflation to stabilize on its own and therefore does not see the need to use interest rates to keep inflation down. Stagnant wages will take care of inflation.

This means ultra-low interest rates are here for as long as the Fed said they would be. Remember when the Fed started talking about stimulus tapering back in May of 2013, and how they prepared us for tapering to start by the end of 2013 and end by the end of 2014? Remember all the debating that ensued, with some claiming tapering would start and end sooner, while others were adamant it would be later?

In the end, what happened? Precisely what the Fed told us would happen. Why should it be any different now? Have we not learned that second-guessing the Fed is futile?

We know who to listen to. Dont fight the Fed. Rates are staying lower for longer. Stay long equities, and dont be afraid of bonds.

Joseph Cafariello

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