February 2017 – Monthly Commentary

February 2017

Economic data released last month was solidly robust, with manufacturing continuing its recent expansion, non-farm payrolls surging, initial unemployment insurance claims touching a 17-year low, and consumer confidence continuing to hit post-crisis highs.  Even the Dallas Fed Manufacturing index outlook skyrocketed to 24.5.  That measure is a diffusion index and indicates that a full 91% of respondents view business as improving or remaining the same – while only 8.7% suggested the economy slipped.   To put that into perspective last year the measure bottomed at -35.8, when only 61% of respondents were looking for business to improve or remain stable. That’s directly attributable to the improvement in energy prices over the last year and the impact they have on the region.

Also noteworthy during the month was the continued uptick in inflation.  Headline CPI rose 2.5% compared to the same period last year, and CPI ex-food and energy, the so called core measure rose 2.3% over the same period.  The core measure is significant in that it is a better representation of the trends in inflation.

The accelerating data seems to have been enough to convince the perpetually dovish Federal Reserve that monetary policy is way too accommodative.  Over the course of the last three weeks, Fed speaker after Fed speaker have said that March was a “live” meeting and that Fed Funds target rate could be raised if economic data continued at the current pace.  For further emphasis, they’ve all suggested that the markets should be prepared for a total of three rate hikes this year.  Judging by valuation in the stock and bond prices, the capital markets seem skeptical of the hawkish talk.  For February bond yields were modestly higher, while equity indices continued to soar.  Similarly, the major foreign exchange pairs have been remarkably stable, despite the significant divergence in monetary policy in Europe, the United Kingdom, and Japan.  The U.S. dollar has traded in a fairly narrow range since the rate hike, frustrating forecasters who predicted a much stronger “buck.”  Many of those forecasters have based their targets on the expectation that negative interest rates in Europe would force Euro savers into the U.S. market.  The problem with that thesis is that to do so, European investors inherit an equity-like risk to generate the approximately 1.5% U.S. deposits offer over the average European savings rate.  As for the idea that a European investor could make a dollar denominated investment and hedge the currency exposure, that is flat wrong.  The foreign exchange market is highly efficient at arbitraging away that advantage with the cost of the hedge wiping out nearly all the interest rate differential.

While it’s seems likely that there will be a rate hike at the March meeting, attention will quickly shift to the post meeting press conference and Chair Yellen’s comments on the pace of hikes going forward.  If the board decides that an additional rate hike at the June meeting may be needed, she’ll need to articulate that possibility now.  We get the sense that markets aren’t exactly prepared for such a discussion.  Stock indices are trading close to record highs, buoyed by corporate buy backs and the seemingly insatiable appetite of price insensitive ETF buyers.  Equally vulnerable is the bond market.  With CPI at 2.50%, the 10-year U.S. Treasury note under normal circumstances would be yielding 4% to 4.5%, not the 2.5% that it offers today.  The same goes for short term interest rates.  The one year Treasury bill currently yields 98 basis points.  That’s implying one rate hike and a small probability of a second.  Working through the math, that security would underperform the market should the Fed raise rates three times.  With so many “crowded” trades in the market, caution is warranted.