On Friday the US released the latest unemployment figures. Although the much hoped for wage increases did not materialize, job growth beat expectations. Private payrolls expanded by 236k versus an expected 210k. But more importantly, the previous month’s disappointing report of 134k was revised upwards to 175k. The unemployment rate fell to 5.9%. Unfortunately the average hourly earnings increase came in at 0.0% versus an expected 0.2%.
We are getting more jobs, but this is not yet resulting in any sort of wage growth for the average worker. Although I am sure that Yellen & Co. would have preferred to see the labour market tightening resulting in raises for the American workforce, it is tough to paint this picture as anything but a hugely positive indication that the US economy is healing.
It is increasingly easier and easier to find a job in America – although some workers’ skills are a little out of date and in need of some upgrading.
This report will make it increasingly difficult for the Federal Reserve doves to continue justifying their extremely easy monetary policy. It pretty well assures that the “considerable time” language will be removed from the Fed’s communique at the next meeting.
Don’t forget that the Fed is at its heart a bureaucracy that operates by committee. Yes, it is heavily influenced by its leader, but it is run by a group charged with a specific mandate. To achieve that mandate, the group relies on many different inputs, but they more or less follow some conventional econometric models. The “character” of the Fed ends up dictating the speed at which they follow those signals. Yet those signals are eventually followed.
I have argued that this Fed is going to be extremely slow to raise rates. I am not changing that view. They are going to be behind the curve for some time to come.
However that doesn’t mean the market is not going to drag rates higher on its own. With the natural improvement in the economy, the market will discount future higher short rates and the Fed will reluctantly follow.
According to many models, the Fed is already significantly behind the curve. Have a look at the traditional Taylor model.
I understand that many economists argue that the traditional Taylor model is not the appropriate yardstick to set interest rates. Many have made adjustments to the model to fine tune it. But only the Evans rule still has optimum Fed Fund rates at negative levels.
|Taylor Rule Name||Fed Funds Rate|
|Stone & McCarthy||1.98%|
As the labour market tightens up, this only pushes the various models’ Fed Funds rate higher.
With this month’s unemployment report coming in better than anticipated, it is going to be increasingly difficult for the Federal Reserve doves to justify the emergency zero rate for the Fed Funds. In the coming weeks, I expect the rhetoric from the hawks to be even more aggressive and that the doves will reluctantly acknowledge that rates need to head higher. Although the Fed wants to be slow in raising rates, even this extremely easy Fed will have to admit that the time for ZIRP is behind us.
The market has already priced in a lot of this move. The short end of the yield curve has been steadily marching higher over the last two months. The US dollar has also been on a tear as higher rates and a better economy are discounted.
I am nervous about the crowded nature of the speculative short positions in the front end of the yield curve, but given the recent employment report, I am reluctant to continue betting on the Fed continuing to dragging their heels. I sold my EDU15 position on Friday’s employment release.
The current market pricing all comes down to a bet on whether the removal of QE will cause another economic and market rollover (as occurred during the end of the previous two QE programs), or whether the US economy is finally ready to stand on its own (it has reached escape velocity.)
Over the past couple of weeks, I was leaning towards the idea that the end of QE was once again going to cause an economic stall, but I am no longer sure.
There was this great quote that came across my twitter stream that I think might be applicable in this situation:
“Remember that the market is a master manipulator. It conditions us to think one way over and over and over until we are finally convinced of a pattern. Just when we think we have things figured out, the market magically changes character.” – Joe Fahmy
I am not going to bother giving you fundamental reasons for either a slowdown or the expansion continuing – I could argue both sides quite easily. If anyone thinks they know for sure, then they are probably kidding themselves. A lot of it is going to depend on the reaction of the US public in the coming months.
However, I will note one thing. When these trends start, they usually go on for longer than almost anyone expects. It feels like the US Dollar has rallied a lot over the past couple of months, but if you step back and look at the longer term picture, this move is just a tiny blip.
And how about short term rates? It feels like they have been zero forever. How realistic is it that this continues for another 5 years?
Maybe the reason there are so many shorts with positions at the front end of the yield curve is that the risk reward is so heavily skewed towards higher rates due to the Fed’s super easy policy up to this point.
Even though trends often continue, that doesn’t mean the other camp is necessarily wrong. At the end of QE1 and QE2, it seemed like we had achieved escape velocity. Things were trending in the same direction as today. Yet as soon as the Fed stopped QE, everything sagged. This might happen again. We might still roll over. The deflationistas that think the US economy can’t stand on its own without QE might well be correct.
But I am not as convinced. And I am scared if they are wrong, the moves that we have seen over the last couple of months in short rates and the US dollar are just the beginning.
My fear about this trend of economic strength (with higher US dollar and higher short rates) continuing might be the best indicator out there that the trend is about to end. There is no doubt that the US dollar is extremely overbought. We are due for a correction in this bull run. Yet sometimes the hardest trades are the ones that never give you a nice correction to buy.
Bailing (probably into the hole)
Given my belief that Friday’s unemployment report has changed the dynamic in terms of the Fed’s willingness to leave rates at zero, I have bailed on quite a few trades. I waited too long for some of these changes as I have been thinking that the US dollar rally would pause. For a tiny little bit it looked like I shorted dollars against Yen at the right time, but Friday quickly broke the US dollar out to new highs and the profit on that trade quickly turned to a loss.
I puked out a lot of my long commodity trades as they have been getting destroyed by the strong US dollar. I tried to catch the falling knife in the precious metals market and that costs me another couple of digits on my fingers.
There is joke on trading desks that there is no such thing as a triple bottom as when a security tests support for the third time, it usually doesn’t hold.
This morning we are bouncing hard as the US dollar is selling off after Friday’s big rally. There is a chance that my capitulation on these trades is going to mark the bottom. It would be just like the Market Gods to put in the turn only when everything becomes completely obvious even to mopes like me.
Nevertheless I am giving up trying to fight the recent trends. If the US economy is indeed able to stand on its own without QE, then the recent moves will be just the beginning.
I am a big believer that surprises in the market never come from where everyone expects. Since the introduction of the first QE program investors have been fearful of a US dollar crash and all the accompanying problems that this would bring about. It is almost a guarantee that given this fear, it wasn’t going to happen. Wouldn’t it be something if the problem ended up being just the opposite? What if the fact that the US was so aggressive with their monetary policy over the past five years has sowed the seeds for a robust expansion that blows the socks off the rest of the world? What if the market crash happens for just the opposite reason – instead of US dollar weakness causing market disruptions, it is US dollar strength that causes all the problems?
I am keeping a little bit of my commodity trades that I believe are still attractive. But I am going to hedge it with a short position in the Yen. I know that it was only last week that I was playing for a move the other way. Flip flopping scares me as it is generally not a good idea. However I want to keep things like my long dated crude and a few commodity stocks. These positions have been crushed in US dollar terms, but if I had been hedged with a long dollar positon, they would have been much better.
For those that have been trying to top tick the US dollar rally, my recent moves are probably the best technical indicator in quite some time that the top might be in…