Market Reaction to Payrolls Data

Payrolls and unemployment reports should normally be regarded to be among the least useful economic data, as they are lagging indicators of the economy. Insofar the recent improvement in employment data only confirms what has already happened: economic activity has increased (note that this tells us nothing about the quality of said activity). It tells us absolutely nothing about the future.

The reason why the markets tend to react strongly to these data is mainly the Federal Reserve’s nonsensical “dual mandate”. Enacted in the heyday of Keynesianism, the mandate is based on the belief that both prices and employment can be successfully centrally planned by manipulating interest rates.

Cumulative non-farm payrolls, initial unemployment claims and the U3 unemployment rate (which excludes about half of the people who are actually unemployed). If we had asserted a few years ago that the Federal Funds rate would be at zero with the unemployment rate at 5.9%, we’d have been declared insane – click to enlarge.

Given the gigantic asset bubble that the Federal Reserve’s policies have produced by means of a near doubling of the broad US money supply since 2008 and by keeping short term interest rates at zero, market participants are understandably concerned about the future course of policy (especially as they are in the agrregate more leveraged than ever before). At the same time, the economy needs to be seen as improving. A decline in economic activity would presumably not be greeted with equanimity.

Below we take a look at how markets greeted the data last week. Many markets reacted just as one would expect, but not all of them did. Further below we will discuss interest rate and inflation expectations.

Stocks and Bonds

The stock market put in what looked like a typical reversal candle on the day prior to the release of the data, and then reacted to the positive payroll data surprise on Friday by rallying strongly. This was incidentally presaged by a bounce in junk bonds which started already on Monday – click to enlarge.

The action in the stock market makes looks as though we have just had yet another 5% dip that will be immediately followed by a rise to a marginal new high, as has been the case many times over the past two years. Accordingly, option traders immediately switched from “slightly cautious” to “quite bullish” within just one trading day, which is certainly a bit faster than usual:

Equity option traders change their market opinion rather quickly this time – click to enlarge.

Oddly enough, although gold and the dollar appeared to confirm the message of the employment data (i.e., rising expectations of a rate hike), the bond market was a bit more reluctant to embrace the good cheer, especially on the long end. The yield curve continues to flatten:

10 year yields initially rose on the back of the jobs data, but almost the entire increase was given back again in short order. The further out on the yield curve one looks, the less confirmation of the “happy days are here again” sentiment is visible, while short term rates increasingly reflect rising expectations of a rate hike – click to enlarge.

Gold, Dollar and Commodities

Gold got duly walloped on Friday, while the dollar continued its recent breakout move. As we noted on occasion of our recent gold sentiment update, the odds that lateral support defined by the 2013 lows in gold will break have certainly increased. Obviously, this doesn’t have to happen, but when a support level is tested a third time, it is usually not likely to hold. At the same time, such a support break is unlikely to be sustained, mainly because current sentiment is by a number of measures among the worst recorded in the past three decades (the current ratio of the XAU index to gold is e.g. the second-worst in the entire history of the index).

Still, if the $1,180 level fails, the $1,040-1,080 area will become the next short term price attractor. The action is incidentally still highly reminiscent of 1976. The technical picture looked almost exactly similar, and the gold-negative fundamentals people were focused on at the time were almost exactly the same as well (rising dollar, improving economy, falling inflation rates…) – even if the absolute levels of the data were quite different from today.

On Friday, gold’s decline accelerated toward the support defined by the 2013 lows. The close was the lowest since 2010 – click to enlarge.

The weekly chart shows the support level discussed above:

Gold approaching lateral support for the third time – click to enlarge.

There still exist a number of small divergences between gold, other precious metals and gold stock indexes that suggest the possibilty that the support level could hold. If it does hold, there will probably be a sizable move in the opposite direction as negative sentiment unwinds somewhat. For instance, small speculators are currently net short gold futures, which happens rarely. However, these divergences are by now far less pronounced than they were previously, so is is difficult to rely on them.

It is worth noting that the dollar has maintained its upward bias in spite of an extreme in the bullish consensus. Traders have never been more bullish on the dollar than today – not even back in 2000/2001. That said, the long term chart does look quite good now, so this consensus isn’t surprising – and the fact that the dollar keeps rising in the face of such a strong consensus is by itself a bullish indication.

A monthly chart of the dollar shows the recent breakout – click to enlarge.

Sentimentrader’s dollar “Optix” indicator show bullish sentiment at an all time high of 88% bulls. This indicator is an average of the most important sentiment surveys – click to enlarge.

Commodities are accordingly under a great deal of pressure. The equal-weighted CCI has recently broken below lateral support (driven partly by extreme weakness in agricultural commodities), but curiously, the industrial metals index has held above its previous lows. This is mainly curious because China’s property bubble seems to be imploding.

The CCI has broken below lateral support – but GYX (industrial metals index) so far remains well above its lows of the past two years – click to enlarge.

Interest Rate and Inflation Expectations

The current consensus expectation is that the Fed will begin to hike the Federal Funds rate sometime between the first and third quarter of 2015. To some extent this consensus expectation is perfectly rational, since the Fed is almost on autopilot with regard to its tightening campaign – the lower the unemployment rate goes, the more likely it becomes that it will stay on course. Note in this context that the “tapering” of QE3 is according to the Fed’s own research roughly equivalent to a 100 basis point rate hike (we are extrapolating: when the $60 billion per month QE2 operation got underway, a report by the Fed came to the conclusion that it was equivalent to a 75 basis point rate cut). So there has already been a considerable amount of tightening – even though we believe this “equivalency” is largely guesswork, the fact remains that QE contributed greatly to pumping up the money supply.

As long as the stock market doesn’t crash and as long as economic activity doesn’t deteriorate markedly, it seems almost certain that a rate hike is on the way.

At the moment, the effective FF rate is stuck at 9 basis points. There is simply no demand for bank reserves, as QE has stuffed the banks with excess reserves up to their gills – click to enlarge.

However, something very odd is happening in the background. Even while there is a general conviction that economic activity is set to continue to accelerate and that rate hikes are therefore certain, inflation expectations have recently been in free-fall. CPI is still close to 2% year-on-year, but has recently turned down again. Falling commodity prices may be one reason for the decline in inflation expectations, but regardless of the reason, we imagine that the Fed under Ms. Yellen (with a very dovish FOMC voting roster next year to boot ) is sooner or later going to shift its attention to inflation expectations, which may become a justification for continuing its loose monetary policy.

The TIP-TLT ratio is a proxy for inflation expectations – it has just reached the lowest level since 2008 – click to enlarge.

Other market-based indicators of inflation expectations are shown below: the 5 year/5-year forward inflation swap rate (which indicates the expectations of CPI inflation over the 5 year period beginning 5 years hence) and 5 year inflation breakevens (straightforward 5 year inflation expectations). Both confirm what we can see in the TIP-TLT ratio.

5 yr./5 yr. forward inflation expectations and 5 year inflation breakevens are both declining sharply as well – click to enlarge.

Most of the time, CPI lags inflation expectations slightly, so lower CPI change rates can probably be expected in coming months. According to its statement, the FOMC’s consensus as of the September meeting was:

“Inflation has been running below the Committee’s longer-run objective. Longer-term inflation expectations have remained stable.”

Given the recent change in inflation expectations, this part of the FOMC statement should be closely watched. Moreover, as Albert Edwards of SocGen has recently pointed out, whenever inflation expectations decline, the stock market tends to become more sensitive to economic data (which probably explains why it rallied on the strong payrolls data). This means that if important leading indicators such as the ISM data should weaken, the market will likely react quite negatively, especially if the recent downtrend in inflation expectations continues.

Conclusion:

Unemployment, not considering about about half the people who remain unemployed but are no longer counted as such, is steadily declining, so the Fed is increasingly likely to tighten monetary policy further. The US economy is however currently the only major economic area experiencing an increase in economic activity. Note that it would be erroneous to refer to an increase in activity brought about by extremely loose monetary policy as “growth”. Since the economy’s price structure is extremely distorted and economic calculation therefore falsified, many seemingly profitable activities are in reality consuming capital. The extent of the echo boom’s capital misallocations will only become visible once the next bust gets underway.

In any event, the rather more obvious economic weakness elsewhere in the world (i.e., Europe, China and Japan as well as emerging markets depending on commodity exports) is pushing inflation expectations lower. This in turn raises real interest rates – hence there is weakness in gold and strength in the US dollar. Moreover, the growth momentum of the US money supply is lately weakening again, in line with its medium-term downtrend.

At some point this combination of factors is likely to produce a big upset in stock markets and in the riskier parts of the bond market universe. The first cracks have become visible throughout the year, as divergences and weakening market internals have proliferated, but experience shows that the market can hold up for extended periods under such conditions. It is not possible to determine ex-ante how big a time lag will be seen this time around (a good fairly recent historical example for an extended time lag between deteriorating internals and the peak in cap-weighted indexes is 1998-2000). However, the longer it takes for bubble activities to stop (whether in financial assets or activities in the real economy that depend on monetary inflation), the more painful the eventual denouement will be. Eventually the greatest article of faith that has every existed among market participants will be put to a test: their enduring faith in the omnipotence of central banks.

Charts by: StockCharts, Sentimentrader, St. Louis Federal Reserve Research