8 Capital Markets Threats to the Central Bank Narrative
Via ConvergEx's Nick Colas,
The jawbone is one of the strongest bits of the human skeleton, and the U.S. Federal Reserve has been hitting capital markets hard with its narrative about raising Fed Funds at its September 16-17 meeting. Now, it appears markets are hitting back. Yes, today’s selloff started with the surprise yuan devaluation, but the moves in everything from crude oil to U.S. government debt signal that investors and traders are telling the Fed to hold off for now.
Will U.S. policymakers listen? Today we list 8 indicators that represent the outlines of this central bank/capital markets debate. Oil is on the list, of course, and a move below $40 over the next month is a flashing yellow light for the Fed. They may speed up, or hit the brakes. Also on our list: Treasury yields (2s and 10s), dollar/euro exchange rates, the S&P (1956, or 5% down on the year is another yellow light), the CBOE VIX Index and the Fed Funds Futures market.
Make no mistake: the Fed marches to its own data-dependent drum. These indicators will only tell you if the central bank has the right tempo to support markets.
Ever notice that the return portion of a trip always feels shorter than the outbound journey? As it turns out, it’s not just you. Researchers at Kyoto University recently published an academic article on the “Return trip effect”. Their study had subjects watch different videos of 20 minute “journeys” and assess how long they took. When the sequence was a round trip, all the subjects felt the return took less time than the outbound segment even though the time elapsed was the same. When the two journeys were not round trips, but rather each one-way, the subjects accurately assessed the time elapsed as the same.
There are numerous theories about why the “Return trip effect” exists. Perhaps the trip back is more familiar and therefore feels like it goes by faster. Or, if you need to be someplace at a certain time – say a dinner reservation – the stress of getting there on time makes the outbound journey feel longer. Another study found that individuals are routinely too optimistic about travel times in the first place, which may exacerbate the stress of the first leg of the trip.
When it comes to capital markets, it is clear that the Federal Reserve’s desire to take us on a trip back to higher interest rates is the source of a lot of “Return journey” angst. The trip down to 0-25 basis point took from June 2007 to December 2008, or 18 months. And we’ve been at this level ever since – 80 months and counting. It seems that no one really wants to get back on the bus and begin the journey home. Yes, we know we have to. But as St. Augustine famously begged, “Not just yet”.
Today’s market action may have been sparked by the surprise revaluation of the Chinese yuan, but we also see plenty of indicators that the U.S. equity market is equally uneasy about getting on the bus with the sign “Final destination: Higher Fed Funds”. Yes, it doesn’t actually leave for a bit – the September 17th meeting is the next possible departure date. But after all, no one knows how fast the bus will go or what exact route it will take. We have a different driver from the outbound leg as well. Now, throw in a series of market indicators that question the need for taking this trip right away, and you have the makings for further market volatility in the weeks ahead.
Here’s what we’re watching over the next month to see if the Federal Reserve will have willing passengers on the trip they have planned. We’re not saying they’ll postpone the whole journey even if markets act up. But if they choose to act in the face of these indicators saying they shouldn’t, today’s volatility will likely seem modest by comparison.
Our watch list:
Crude oil prices. Close today: $43.08. Warning sign below $40. Oil prices are the equivalent of blood pressure readings for the global economy. You don’t want them too high, or too low, or moving around too much. Over the last 12 months we’ve had all three. The move below $50/barrel since July 23rd wasn’t really driven by news of incremental supply. Rather, it was largely over concerns related to the Chinese economy. In talking this over with our trading desk, we all agreed that anything with a “3 Handle” – below $40 in non-traderspeak – will create more concerns about global growth than already exist.
Why should the Fed care? On their 2 item congressionally mandated “To do” list, they can check off employment as “Done”. Inflation is another matter, and given how pervasive oil is in the domestic economy crude prices below $40 have to be a concern even if they are “Transitory”.
2 Year Treasury Yields. Close today 0.68%. Warning sign below 0.50%. Ever since June the short end of the Treasury yield curve has been convinced a Fed Funds rate increase was pretty much inevitable. Yields on the 2 year hovered between 65 and 75 basis points with only one short break down to 55 basis points. Today those yields went from 73 basis points to 68. Anything approaching 50 basis points is a red flag; just look at the one year chart for January and April 2015, when concerns over Greece pushed yields lower. They went right to 50 bp before bouncing.
10 Year Treasury Yields. Close today 2.14%. Warning sign below 2.0%. It wasn’t so long ago that the 10 year seemed destined to top 2.5%. Now it seems gravitationally attracted to 2.0% again. It did break down below that level earlier in the year (again, due to the Greek debt talks) but another move below 2% wouldn’t be about Europe this time. Rather, it would be concerns over U.S. economic growth in the face of a rising dollar and worries over lower inflation rates due to falling oil prices. This is another indicator our senior traders are watching closely.
10 – 2 Treasury Spread. Close today 147. Warning sign 138. Two year yields can only fall so much, so how far down will 10 year rates go relative to the shorter maturities? A smaller spread is the bond market’s way of saying that long term economic growth is likely slowing and/or inflation is less of factor. The year to date low on the 10-2 spread is 121 basis points, back in early February. Our warning sign level of 138 is the average of February – April timeframe.
Dollar/euro exchange rate. Close today 1.104. Warning sign $1.09. Back to our trading desk for a minute – this was another key indicator they felt was critical to U.S. equity investor psychology. Much more dollar strength, they feel, would force analysts and companies to cut earnings expectations for the back half of the year and possibly 2016. With valuations already feeling toppy, that would be bad for equity market sentiment.
S&P 500. Close today 2084. Warning sign 1956. We began 2015 with the S&P 500 at 2059. A 5% pullback would take us to 1956. Would the Fed move if equities were halfway to “Correction territory” for the year? The equity market is not part of the congressional mandate, of course, but would they have the confidence to bump rates in this environment?
CBOE VIX Index. Close today 13.71. Warning sign: over 20 for 5 days straight. The last time the VIX was above 20 (its historical average back to 1990) for more than 5 days was October 2014. Just as with the prior point, the Fed is not supposed to be the market’s guardian. But this level of volatility would feel very uncomfortable for policymakers and investors alike.
Fed Funds Futures. Close today: 45% chance of a September hike. Warning sign: 40% or less. The CME Group’s FedWatch product is an assessment of the Fed Funds Futures market, handicapping the chance for a rate increase based on market prices for these contracts. Right now, this indicator says it is just slightly better than a coin toss that the Fed will not move rates in September. Yesterday, the odds were just slightly better that they would – 54% to be exact. You can use this as a proxy for how “Prepared” markets are for a Fed move. If the odds move to 40% or less and stay there, the Fed acts at its own peril.
That sentiment – that the Fed may move even if all these levels are breached – is the essence of the market’s present dialog with the central bank. They do have a different agenda than capital markets, after all. In the end, things work out better when the Fed listens to the market and vice versa. But if they want us to get on the bus, we’re going to take a ride. How long that trip feels… Well, that’s another matter.
