We are again back to a period when the markets’ hang on every word uttered by a central banker. Anecdotally, we have seen an increase in inquiry around central bank expectations and their potential impact on varying asset classes, so we know it’s the topic du jour. This very may be the theme that drives us into the end of the year, as the most market moving events over the past few weeks can be attributed to CB speak. The main actors have been the Fed, ECB and Bank of China, while supporting roles were given to the central bankers in Japan, Canada, Brazil, Turkey, New Zealand, Sweden and Mexico. The overwhelming commentary has been of the dovish bent during many of these recent meetings, with bankers either announcing new QE measures or signaling their willingness to act further (ECB, China, Riksbank, BOJ). Even countries facing inflation and weakening currencies (Turkey, Brazil, Mexico) have remained on the sidelines, partially swayed by potential actions from the larger central banks.
Of course the Fed stands in contrast to these dovish proclamations as it sent a clear message that it wanted to start the rate hiking process this year. The following statement could not have been clearer:
In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation.
Additionally, the removal of specific discussion over global economic and financial market volatility has lowered the bar for hikes, which we thought was raised following the September meetings. The futures markets reflects this new reality, as the odds have risen from 30% before the FOMC meeting to 50% recently. Of course, 50% is far from a rousing endorsement of what the FOMC seems to imply is a sure bet. The recent weakening of data, along with the continued lack of inflationary pressures are two of the larger hurdles that the committee must overcome. Whether Fed lift-off will re-stoke monetary divergence issues is also a concern, particularly given the increasingly dovish positions taken by the global central banking community. A stronger USD, tightening credit conditions, commodity weakness and increased volatility seem to ensue every time we try and go down this rabbit hole. While we acknowledge that the odds of a December lift-off have improved, we remain skeptical over the committee’s verve to actually start the process, as it has flinched during a few opportune moments this year. We are therefore sticking to our March, 2016 guess for lift-off, having lost a bit of faith after the September meeting.
We also view some of the recent Fed rhetoric as preserving the opportunity for a December hike, which would have been challenging if the market continued to assign low odds on that event. Instead, we have seen rates higher over the past week, with the belly underperforming the wings as the curve have steepened through the belly, while remaining mostly unchanged though the long end. This is likely due to the overly benign hiking expectations assigned by the market, with the Fed guiding to 5 hikes by y/e 2016 and the market expecting only 2 prior to last week’s meeting. While that gap has now closed to three expected hikes, continued market stability should continue to narrow this gap via higher yields. Global rates have also generally risen over the past week, although EGBs mostly reversed the rally they experienced following the ECB meeting a few weeks ago. Currencies have been mostly unchanged since the FOMC, with the ECB meeting having a much bigger influence on strengthening the USD and weakening the Euro. Recent comments from Mario Draghi have been somewhat conflicting, saying that further stimulus is an “open question” over the weekend, while today reaffirming their willingness to act at the December meeting if needed. We get the sense that these are trial balloons that may lead to market disappointment given how consensus firmly expects addition QE to come from ECB’s December 3rd meeting. The Euro bond markets have been whipsawed on these contrasting statements, the 10y Bund trading down to 20 bps to 42 bps just after the ECB, but rising back to 58 bps after this Draghi’s weekend comments. The Euro has traded between 1.09 and 1.13 over the past 2-weeeks, and is presently weakening back to the low end of that range.
Equities have been the strongest performers over the past several weeks, as most U.S. stock indices are now positive for the year. The post-ECB stock rally was driven by the safest sectors, with healthcare, technology and financials leading the rally though mid-October move. More recently, however, it has been all about energy, with that sector up 6% over the past week alone. Oil has helped, stabilizing in the upper $40 range, while the brent/wti spread has been mostly unchanged. We are therefore back to levels last seen just before the Chinese government devalued the Renminbi. The strong performance of stocks is especially impressive given the generally weak results from corporate America during earnings season. While approximately 70% of companies are beating expectations, revenues are missing expectations almost 60% of the time. Earnings also look set to fall on a y/y basis for a second consecutive quarter, while current quarter expectations call for yet another decline in earnings. Since there are limited earnings next week, we expect that current results will hold steady through the end of the reporting season.
The risk rally has also spread into the fixed income markets, with high-yield, preferred and emerging market debt posting 2%-3% total return gains during October. The broad aggregate was mostly unchanged, while generally higher yields pushed the treasury index into negative territory (-0.4%) for the first time since June. Most of the other fixed income asset classes were flat to slightly positive for October, while YTD returns are not much better, although many bond classes are still outperforming the S&P for the year. Corporate spreads have been generally stable over the past few weeks despite a strong finish for new issuance at the end of the month. Monthly investment grade issuance exceeded $100 billion, setting yet another monthly record. November has seasonally been an active period for the primary market, with $112 billion average over the past 3-years. With rate hike expectations rising, continued M&A activity, and a reportedly robust calendar, we would expect to exceed $100 billion again this month. This will likely cap much more spread compression, although think we have seen the wides of the year. High-yield also continues to rally, buoyed by strong inflows into the asset class.
All of this points to fairly well behaved capital markets, which strengthens the odds of a December rate hike. We nonetheless remain data dependent, with Friday’s employment report the spot light for the week. Recall that non-farms have disappointed for 2-consecutive months, with last month’s +142,000 widely missing expectations, while also not containing the expected positive revisions to August. The current consensus expects +180,000 jobs for the month, with positive revisions also expected for September’s data. Various fed speakers have talked down employment expectations recently, citing the need for only 120,000 thousand jobs to maintain the unemployment rate. Average hourly employment has become increasingly important as the market searches for wage inflation, so look for a rebound from the 0% reading last month. There is limited data next week, with the bond market closed on Wednesday for Veterans Day. The key releases next week will be retail sales next Thursday and Michigan confidence on Friday.