Investors getting nervous

By David Morrison  |  05/10/2018 14:38

After Thursday’s sharp jump in longer-dated US Treasury yields and stock market sell-off, investors were on edge ahead of the September Non-Farm Payroll release
 
Jitters were palpable following Thursday’s stock market sell-off as investors primed themselves for the September Non-Farm Payroll numbers. Ahead of the release there had been whispers that Non-Farms could blow well past the +185,000-forecast following an unexpectedly-strong ADP number on Wednesday. This would have added to concerns that the US economy was overheating and force the Federal Reserve to accelerate the pace of monetary tightening.

Initial relief

Consequently, there was initial relief and a corresponding bounce in European and US stock indices after the headline Non-Farm Payrolls rose just 134,000 – well below initial expectations and the prior month’s reading of +201,000. On top of that, the rise in Average Hourly Earnings came in at +0.3% month-on-month as anticipated – down from +0.4% previously. As with the payroll number this helped to calm fears that inflation was taking off. However, the Unemployment Rate fell to 3.7% - its lowest level in 49 years – which points to a tight labour market and the assumption that wage growth can only pick up from here. Maybe. In addition, a quick look under the hood of the payroll data shows that some of the lost jobs were the one-off effect of Hurricane Florence. On top of this, August Non-Farms were revised up by 69,000 and July’s up by 18,000. All-in-all, not nearly as disappointing as first thought and consequently no relief for those worried about rising inflationary pressures.

Yields rise further

The rally in equities reversed quickly as yields on longer-dated US Treasuries jumped higher and the Volatility Index (VIX) flash-crashed. This suggested that the economic data was too confusing for trading algorithms to process cleanly. All-in-all, as the US open approached, it was fair to say that the session was likely to bring an interesting end to the trading week. This was especially the case as Monday sees Chinese markets reopen after their Golden Week break, and the third-quarter earnings season gets underway next Friday.

Rate of change

Markets were rattled by this week’s sudden sell-off in US Treasury bonds and the corresponding jump in yields to ‘danger’ levels. At 3.23% the yield on the 10-year note hit its highest level since 2011. But what was more significant was the speed at which it did it. What was doubly shocking, and what really unnerved equity markets, was that it came as ‘large speculators’ already had a record short position in US Treasuries. This raised questions about where the fresh selling came from, who’s no longer buying and whether this dynamic will continue.

Upbeat data

The sell-off came on the back of a raft of better-than-expected US data releases (including the ISM Non-Manufacturing report, ADP Payrolls and Factory Orders) and hawkish comments from Federal Reserve Chairman Jerome Powell. This added to fears that the US economy is heating up, boosted by the Trump administration’s tax cuts and fiscal stimulus.

Powell at the Fed

Some of the problem appears to be a fundamental misreading of how the Fed operates under Chairman Powell. Even before he took up this role, it was apparent that he is of a different species from his predecessors, Janet Yellen, Ben Bernanke and even Alan Greenspan. For a start, Mr Powell isn’t an academic economist. Rather, his background is in law and private equity which means he has practical business experience outside of the usual ivory towers. On top of this, years before his appointment as Chairman, Powell had commented on the risks of an easy monetary policy, particularly when it comes to asset bubbles.

Is there a ‘Powell Put’?

Following his second speech this week, Mr Powell was asked about the risks of tightening monetary policy either too quickly or too slowly. The Fed Chairman said that in the latter case there’s a risk that the economy overheats leading to too high inflation or “financial market imbalances” (bubbles to you and me). This was yet another sign that, assuming there is such a thing as a ‘Powell Put’ (like the Greenspan, Bernanke and Yellen Puts which prevented any significant stock market correction), it’s likely to kick in after a much bigger percentage fall in the S&P 500 than those of his predecessors. He also said that US interest rates are “still accommodative” and that the Fed was “gradually moving to a place where they will be neutral.” He went on to say: “We may go past neutral, but we’re a long way from neutral [currently 2.25%] at this point, probably.”

The neutral rate

The neutral (Goldilocks) rate is the interest rate that neither stimulates nor restrains the economy. The issue that’s currently exercising market participants is guessing where the Fed thinks it is. The problem is, despite getting some decent clues into the Fed’s thinking, the market has repeatedly misread the signals as to just how hawkish the central bank may prove to be under Jerome Powell. But this week Jerome Powell made it abundantly he believes we’re a long way below it.

Next week’s data

Wednesday brings us the first look at UK third quarter GDP. On Thursday we have the latest update on US CPI along with the release of minutes from the last ECB monetary policy meeting. Then on Friday we get numbers on China’s Trade Balance which has been thrown into sharp relief with the ongoing US/China tariff dispute. Friday also sees the first day of IMF meetings.

Third quarter earnings

But perhaps most importantly, the third quarter earnings season kicks off in a week’s time with releases from Citigroup, JP Morgan, PNC Financial and Wells Fargo. Will we see another blow-out quarter which will help drive the major US indices to fresh record highs? Or is the best now behind us while concerns grow about the overreliance on stock buybacks and dividends to push corporate share prices higher? In the current environment where investors are increasingly concerned that the Fed may tighten monetary policy too far too fast, any earnings disappointments, or an uptick in negative forward guidance could lead to investors switching from bullish to bearish very quickly.
 
 
 
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