October 2015 – Monthly Commentary
Following two consecutive months of disappointment, the October employment report far exceeded expectations, adding 271,000 for the period. With the big addition, the unemployment rate fell to 5.0% and could fall below that measure as early as next month. Reflecting the tightening of the labor force, average hourly earnings rose 2.5% year-over-year, which has accelerated from the 2.0% year-over-year growth witnessed in the first half of this year.
With the blockbuster October jobs report, we believe the FOMC has all the ammunition they need to finally lift emergency monetary policy for the first time in seven years. However, we’re reluctant to say that a Fed rate hike in December is a lock. Chair Yellen has done the “bait and switch” on too many occasions for us to say that it’s a certainty. Also, the December committee meeting concludes on the 16th of the month, which is likely to pose a problem. By that time, trading desks have virtually closed their books for the year, with liquidity thin and trading sporadic. Nevertheless, the strength in the employment report is likely to force them to move on or before that meeting or risk further erosion of their credibility. One option would be to schedule an interim meeting and a follow-up news conference prior to the December meeting. Of course, once such an event was announced, the markets would immediately interpret the move as a rate hike and react accordingly. That outcome would probably not be palatable to the committee, but we think that keeping investors guessing until markets reach the nadir of illiquidity would be even less palatable.
Ironically, before Friday, investors had been debating whether the August into September stock market swoon and the slowdown in manufacturing were precursors to a recession or simply a mid cycle slowdown. Contributing to the worry, Minnesota Federal Reserve President Kocherlakota, in September, advocated that the Fed Funds target should be lowered -0.25%. While we took note of the slowdown, we weren’t convinced that it was anything more than coincidental. Anecdotal evidence of that could be found in the ongoing pace of automobile and home sales. New Cars sold at an 18.12 million annual rate in October, eclipsing the 18.07 million annual rate registered in September. Typically an annual sales rate of 16.5 million vehicles is considered strong. Similarly, the housing market continues to surprise to the upside with the home builder’s index, building permits, and housing starts all registering impressive gains. New home sales are an especially potent driver of economic activity, as increased building pulls workers into the workforce. Moreover, the material, equipment and supply purchases creates a virtuous cycle of demand. The virtuous cycle is perpetuated as the new occupants purchase household goods, including furniture, carpeting, drapes, appliances and all the various items that go into turning a house into a home.
The rebound in economic activity has coincided with a blistering rally in stock prices, as short sellers were forced to cover as prices rose. The S&P 500 rallied 8.3% in October as the short sellers scrambled to cover losing positions. As expected, bond yields rose on the bullish stock market and rebounding economy with the yield-to-maturity of the 2-year note rising to 0.88% from a recent low of 0.60%. Similarly, the yield on the 30-year bond rose to 3.08% from a recent low of 2.74%. Despite the sharp rise in yield, the market-implied level of Fed Funds next October is only 75 basis points. With that, investors are implying that the Fed will only hike rates two times over the course of the next twelve months. If the economy has moved to full employment, as we believe may be the case, the Fed is likely to become a little less patient than they have communicated.