Rising Rates Causing Indigestion
The story of the week was the bond market. U.S. Treasury bonds sold off sharply as interest rates increased across the curve. For the week the yield on the 10-year Treasury increased from 3.06% to 3.22%, a +16bps increase. Two-year yields were up +6bps. As a result, intermediate-term Treasury bonds lost -1.2% for the week while long-term bonds were down -3.4%.
For most of the year rising rates haven’t caused many headaches for stocks, but that changed this week. The S&P fell -1.0% on the week while small-caps lost 3.7-%. Emerging markets were hard hit with a -4.8% loss.
What’s behind the increase in yields?
So far the story is more about a robust growth backdrop than rising inflation. There were three key economic reports this week that supported this idea.
The monthly report on job growth was a bit of a mixed bag, but the underlying fundamentals were solid. Monthly payroll growth (chart below) came in a bit soft at +134K, roughly 50K short of expectations. Hurricane Florence undoubtedly played a part.
But prior months were revised higher – July from 147,000 to 165,000 and August from 201,000 to 270,000. Wage growth was generally in line with expectations. However, it is notable that the unemployment rate fell to its lowest level since 1969, as you can see below.
Weekly Unemployment Claims
Weekly unemployment claims fell to their lowest level since 1970, at roughly 200K. This is really saying something because in 1970 the labor market was made up of roughly 82 million people. Today it is 160 million.
Finally, the ISM survey of services jumped to a two-decade high. The ISM non-manufacturing number hit 61.6 last month from 58.5. It’s the highest point of the current nine-year-old expansion and the second strongest reading in the history of an index whose roots stretch back to 1997.
The Fed Thinks It Has Much Further to Go
Another factor behind rising rates is the growing belief that the Fed will actually go through with their plan, if not a bit more. The market thinks rate hikes will stop some time in 2019 at roughly 2.9%. However, there is a growing view that we could see 3.5% before this cycle is over. Chairman Powell’s comments this week reinforced this latter view.
Specifically, he said that “we’re a long way from neutral, probably.” Powell also added that “we may go past neutral.” This came on the heels of comment from Chicago Federal Reserve President Charles Evans, who reiterated his expectation that rates will eventually turn restrictive.
Now while the Fed members may disagree on where neutral is, the majority if not all expect rates will climb above their estimate of neutral. In other words, they all see policy as becoming restrictive at some point in the next couple of years.
It Makes a Difference Why Rates Are Going Up
So how worried should investors be about rising rates?
Probably not much, at least at the moment. One reason is that most of the rise in yields is due to rising real yields. By way of background, there are two components to yields. There is the real rate of return plus an inflation premium. Today’s 10-year yield is made up of roughly a 1% real yield and 2.2% inflation adjustment. Much of the recent increase in rates is due to rising real yields – 10-year real yields just moved above 1% for the first time since 2011. Rising rates that simply reflect better growth prospects is much more palatable than rates that are going up because of an inflation shock.
Another point is the recent steepening in the yield curve. Up until a couple weeks ago it looked like the curve was headed towards inversion. However, this week the curve steepened meaningfully, another sign of better growth expectations versus an impending slowdown.
Finally, while a bit on the Ouija Board side of things, seasonal patterns look interesting. The chart from Nautilus below shows the pattern for the S&P going into the mid-terms. Typically, October, November, and December around the mid-terms is positive for the market, and 1-month, 3-month, and 6-month forward returns are solidly green with a good batting average.
For example, during the last 22 mid-term periods, 19 have been positive 6-months later with an average return of +12.45%. Could this cycle be different? Without question. Nothing about the political backdrop is normal today. But political gridlock after the mid-terms might not be so bad.
Pushing Out the Recession Call
While it’s impossible to know how long this stock market correction can run, there is a subtle change taking place among analysts. Around the middle of the year there seemed to be a broad consensus that we were due for a recession in the U.S. by the end of 2019 or early 2020. The thinking was that three or four more rate hikes would undermine the economy, the yield curve would invert in the first half of 2019 in anticipation of a recession, and the actual recession would start six-to-nine months later.
This meant the market was due to peak in early-to-mid 2019. Look at the table from Bank Credit Analyst below. It shows that on average the S&P typically peaks 7 months before the start of a recession and bottoms 8 months after the start. So, if the recession was going to start at the begging of 2020, stocks should peak around the middle of next year.
However, some analysts are starting to think growth will be more resilient to rising rates than originally thought. This means the recession call is getting pushed further out. The following comments from Ed Yardeni are worth a read:
“So what will it take to snare the bull in the bear traps? It will take a recession. That’s all there is to it. While Goldman and everyone else is on the lookout for this event, both the Index of Leading Economic Indicators (LEI) and the Index of Coincident Economic Indicators (CEI) rose to new record highs during August (Fig. 11). The LEI did so even though the yield curve spread, which is only one of this index’s 10 components, has been narrowing fairly steadily since 2013, but remains positive. It only subtracts from the LEI when it is negative. So it is still contributing positively to the LEI, though to a lesser extent. History shows that the CEI, which is a good monthly proxy for quarterly real GDP, falls when a financial crisis occurs, triggering a credit crunch and a recession. There’s no sign that scenario is about to play out again anytime soon.”
And by soon he means the next twelve-to-eighteen months. Bank Credit Analyst is but one of many groups that is re-evaluating their recession call:
“The current U.S. economic expansion will become the longest on record if it makes it to July 2019, at which means it will surpass the 1990’s expansion. Will it last that long? We think so. In fact, the risk to our 2020 recession call is tilted towards a later downturn rather than an earlier one.”
Have a good weekend.
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