MorningWord 12/4/15: Don’t Ease Me In

by Dan December 4, 2015 9:48 am • Commentary

The November jobs data just put the final nail in the coffin for the Fed to lift fed funds rate in December for the first time since June 2006.  The yield on the ten year Treasury is approaching 6 month highs and the yield on the 2 year Treasury is at it highest levels since early 2010, nearing the psychologically important 1% level.  Rate traders have run ahead of the hike.

Running ahead of central bank monetary policy has been the modus operandi for large investment pools since the Fed hinted in May o0f 2013 to a Tapering of their monthly bond buying (QE), and the subsequent end of QE in October of 2014.  The result have been unrelenting unwinds of consensus trades that were very crowded given what for years was a Fed that was unwavering in their desire to prop up risk assets and weaken the dollar.  Since the start of the Taper, we have seen new-found volatility in credit markets, crashes in commodities like oil, copper, steel… you name it, which obviously corresponded with a crash up in the U.S. dollar.  For all intents and purposes there has been nearly a two year period of rolling risk asset corrections, with equities generally spared.

Will the impending end of ZIRP in two weeks be the spark that ignites a new volatility regime for U.S. equities?  There is no easy answer to this question. But let me take a crack. This week we have had weak manufacturing and services data for the month of November, and then this morning’s jobs data that was essentially in line. If the Nov jobs data was weak, it would have been a very easy case to make that the Fed should wait on a liftoff, especially as we head into Q1, a period that has been seasonally very weak for U.S. GDP all through the recovery since the financial crisis.  Given the fragility of the global economy it seems that the Fed is more concerned about getting Fed Funds to a level where they can in fact cut again if we hit economic turbulence. They are not worried that the economy will overheat if they leave rates too low for too long.

The last two days downward volatility (about 2.5% in the SPX) reflects investors’ mild ease with the notion of the Fed being backed into a corner on a rate increase. Anyone who tells you that a 25 basis point raise in Fed Funds is nothing to worry about is speaking of things they know nothing about. The Fed Funds rate has never been raised from zero. And never after a period of 7 years of extraordinary monetary response to the most dramatic financial crisis since the Great Depression.

There is not shortage of data that suggests that stocks can continue to rally in a rising rate environment, but again, there is no historical data that gives us a playbook for the environment we are in. It is my sense that 2016 will at best reflect the tensions manifested in the S&P 500’s price action in 2015, where the path of least resistance is no longer higher.  If the SPX can find its footing, and the Fed is very careful with their guidance about future rate increases following December, then I suspect that we close up or down a few percent from current levels. But we will be very susceptible to the sort of 5% (at minimum) sell off that we have seen in the last two Januaries.