Favorable Jobs Data Sets the Stage for a Fed Hike and a Stronger Greenback

Tom Cleveland

The Ides of March are upon us. Should we beware the day from yore and heed its dire warnings, or pretend the “New Normal” will make all things peaches and cream? As luck would have it, the Fed convenes on this auspicious day, and, although it marked a turning point in Roman history and the demise of Julius Caesar, will it have the same significance for us and portend an economic transition to who knows what? Such is the uncertainty of our times that we must resort to historical references for guidance, but, as they say, it is what it is. Accept it, and move on.

Today’s jobs report was stellar in quite a few ways and suddenly shifted the spotlight back to its original Fed-Watch position. Will the Fed hike rates next week? It is the question that is consuming the mind of nearly every analyst on Wall Street before Happy Hour convenes this Friday afternoon. In the States, we also have to contend with losing sleep, as Daylight Savings Time springs our clocks forward this weekend. We will have one less hour to worry about potential market reactions in the week to come, but at least the Sun will set later on the horizon. Are you still embedded in your Long-Dollar trades? Will the greenback jump again or has it played out its last dash? Time will tell.

Dollar Bills

Yes, the Dollar could strengthen yet again next week, unless today’s investors were a little quicker out of the starting blocks this time around. We may finally see a sell-on-the-news reaction from the intrepid USD Index, which presently sits at 101.3, down a bit on a the jobs report. This level happens also to be a firm support platform from which to bounce higher, perhaps, to 104 or even loftier realms of 106 and beyond. Some analysts do not see a limit, but resistance has a way of cropping up once profit taking takes hold.

Should we fear the Ides of March? March 15th is quickly approaching. Fed governors have been on the speaking trail, acting as if their “Normalization” plans are full speed ahead. Janet Yellen has not said anything to the contrary, but, if the “fix” is in, what will another 25 basis points do to our overly bought markets? Sentiment measures are signaling a top formation, and according to Jeff Saut of the Business Insider, “Corporate insiders sold $7.8 billion of their companies’ stock in February, which was the most in roughly six years.” What do they know that we do not?

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Old Fed hike debates are being rejuvenated with alarm bells ringing.

Irrational exuberance can baffle even the best analytical models. It has a way of buoying markets well beyond anyone’s expectations, but markets do have a way of finally correcting. Investors will reach a place where they do not want to be the “greater fool”, and this mentality, over time, tends to tame any bullish tendencies. From an historical perspective, the one thing that seems to get the dominos falling is a hike in interest rates, as depicted in the chart below:

Fed Rate Hike History

Hiking interest rates in the past, when real economic growth levels were low, has had disastrous results, a dire warning from the data presented in the above pictorial. Donald Trump also has his work cut out for him if he is to restore real GDP growth levels to 3% to 4% and even higher, as he promised on the campaign trail. Over the past seventy years, the 5-year rolling average topped 4% on only three occasions, and these occurrences were before the advent of China and our globally entwined economy.

It is also difficult to ignore that the 5-year rolling average of real GDP growth is the lowest it has ever been in the seventy-year period, having experienced from the sixties forward a gradually declining slope that, hopefully, has finally bottomed out. If we had added the growth figures for the developing economies of the world, we would see where the growth went. The past six decades or so have been the greatest redistribution of wealth that the world has ever seen. Developed economies may have suffered, but global poverty statistics have come way down in the process. This dramatic result, which was decades in the making, is now the primary reason for the cyclical revival of populist and protectionist sentiments across Europe and North America. The good times have waned in developed economies, while champagne corks are popping elsewhere.

If the green arrows in the chart are to be believed, then the forecast is for recessionary pressures to build over the remainder of this year with a business slowdown occurring in the 2018 timeframe. In this case, the author of this chart could be accused of presenting too much data. The eye can only gather so much input before it gets distracted. The author, however has this counsel: “There have only been TWO previous points in history where real economic growth was near 2% at the time of the first quarterly rate hike – 1948 and 1980. In 1948, the recession occurred ONE-quarter later and THREE-quarters following the first hike in 1980.” Yes, these times are different, but are they really?

If equities correct big time, how large of a correction can we expect?

The author of the previous chart may have had too much time on his hands, but, I have to admit, he is after my own heart. I prefer to come at an issue from several directions, and then reconcile any differences. The analysis becomes more credible, when more data points point to the same result. The next chart, also prepared by this fellow, needlessly goes back to the 1800’s, but the significance of his analysis is borne out over the key period from 1943 to the present. Take a look:

Recoveries and Declines

Let’s focus on 1943 forward. As real GDP growth has declined, the length of recovery periods has increased, as have the subsequent market declines. Our present Bull market recovery is now the third longest on record and will overtake second place with another twelve months of positive grind. But, are we building ourselves up for a terrible fall down the road, something in excess of a 50% negative correction? Is this event going to be the liquidity crunch of the century that central bankers have been warning against for the past few years?

It would appear that our low growth rate, long recovery period, and the potential for rising interest rates are pointing to a major collision point, roughly one year down the road. The potential for such a train wreck is exacerbated by the fact that our real GDP growth is lingering around and below 2%. At a 3% level, the economy would have some “wiggle room”, so to speak, to adjust and adapt to changes in fundamental forces. In other words, it is what it is until it is not, or, as this author points out, “For those asleep at the wheel, there will be a heavy price to pay when the taillights turn red.”

Why will change come so abruptly? Rising interest rates can eat away at many aspects of the economy, until the final straw comes along. The housing market suffers. Debt service for companies takes capital away from investment. Corporate profit margins and earnings per share are squeezed. Consumer spending is curtailed. The pressure builds on several fronts at the same time. Lastly, “There have been absolutely ZERO times in history that the Federal Reserve has begun an interest rate hiking campaign that has not eventually led to a negative outcome.” To be forewarned is to be forearmed!

Did new job data solidify the odds for a Fed rate hike on Wednesday?

The air in the USD Index balloon quickly expanded after the extremely positive ADP data release on Wednesday. As reported, “The crowd was looking for a gain of 183,000, based on Econoday.com’s consensus forecast. The actual increase was sharply higher at a sizzling 298,000.” This “sizzle” may have pushed the index beyond an untenable position, but correlations between ADP historical data and the DOL’s Non-Farm Payroll report have only worked when looking at a multi-period rolling average approach.

Expectations for Friday’s release quickly rose from 190,000 to 200,000. The final numbers were actually 235,000, a result that President Trump immediately took credit for, even though the real reason may have been due to the warmest winter in 122 years. Alan Gayle, director of asset allocation at Ridgeworth Investments, spoke to the reasons behind the higher than expected jobs increase: “I suspect that there is a positive impact from milder weather in February which may have skewed this number to the high side. But the operative message is that the jobs market continues to strengthen, and that is likely to give the FOMC a green light to raise rates when they meet next week.”

The futures market had already re-calibrated after the ADP report. The probability for a rate hike tops out at 90%, having been as low as 33% back in January. Wage increases were moderate, actually 0.1% below expectations, but on an annual basis, wages did grow by 2.8%, in line with Fed inflation estimates and a key factor monitored by the Fed in determining if there is slack in the labor market. Unemployment also dropped to 4.7% from 4.8%. All in all, it was a good report and provided assurances that the Fed will act in accordance with its desire to move “Normalization” forward.

Concluding Remarks

Beware the Ides of March! An interest rate hike in the Fed’s primary benchmark measure is a 90% certainty. Forex markets took the news in stride. Major pairings adjusted less than 100 pips across the board in a broad sell-on-the-news response. The Dollar slightly weakened, as a result, but next week may be a different story. Prices for 10-Year Treasuries have also fallen for nine straight days, causing yields to crest at 2.62%, the highest level for that data point since the Fed achieved lift off last December.

How will the U.S. Dollar react next week? Per one analyst, “Look for next week’s events (FOMC meeting, Dutch election, and G20 meeting) to limit the dollar’s downside, barring a significant disappointment that makes participants doubt the certainty of a hike next week. Rather than a repeat of last week’s ‘buy-the-rumor, sell-the-fact’, we suspect the opposite. The two weeks of rising US yields (a 10th day of rising 10-year yields would be the longest such streak since the mid-1970s) warns of a potential turning point in the market.” Stay tuned!

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Tom Cleveland
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