Markets have had a full week to digest the very strong US jobs report, as well as signs of progress in the China-US trade talks. Yet despite the positive news, investors and traders believe the Federal Reserve will stop hiking interest rates this year and will cut them in both 2020 and 2021.
The discrepancy between the markets’ interest rate view and the positive jobs report, and how this difference is eventually resolved, have important implications for investment strategies in the year.
The blowout employment report released January 4 showed that the US economy created 312,000 jobs in December, almost twice consensus expectations. Adding to signs of a strong labour market, the previous two months’ readings were revised upward and wage growth rose to 3.2 per cent, suggesting that the household sector, the main driver of growth in the US economy, is strong.
This positive sign for consumption would normally encourage companies to boost output and capacity, adding to the growth impetus. In addition, the budget approved by the previous Congress contains continued fiscal stimulus for this year.
Yields on US Treasuries moved up from their depressed levels at the market close on January 3, the day before the release of the jobs reports. The two-year bond rose to 2.54 per cent on January 11 from 2.38 per cent, and the 10-year to just over 2.70 per cent from under 2.60 per cent. Yet overall levels remain relatively low given the strength of the labour market data.
Moreover, the difference between these two maturities, historically regarded as a signal of growth prospects, remains at a worrisome low level of 16 basis points.
The contrast between the implied market pricing for the fed funds rate and the central bank’s “blue dots” is also notable. The markets, anticipating no hikes this year and cuts thereafter, estimate the fed funds rate in 2020 a full percentage point below the median of the central bank’s dots.
Several reasons have been put forward to explain this striking and consequential difference. Determining which of these explanations, alone or in combination, is the most valid really matters for investors’ portfolio positioning.
For example, the first scenario (structural upside to the US economy) would imply considerable secular risk taking and tolerance for volatility given that fundamentals would drive the economy and markets forward and wouldn’t be derailed by premature Fed tightening. The second explanation (the Fed cowed by markets) would suggest a more tactical risk positioning, which involves surfing the central bank liquidity wave once again but being ready to get off before it breaks.
The other possibilities suggest up-in-quality trades and more defensive investment positioning.
As frustrating as this is, there simply isn’t enough data as yet to point with a high degree of confidence to a dominating explanation or combination of explanations. In addition, most model portfolios and, more generally, historically based analytical models may not be sufficiently structurally robust to capture this moment accurately.
Rather than let this uncertainty lead to either paralysis or excessive speculation about the influence of one or more tentative explanations, investors should take away three messages: We are in a period of inherently greater economic, policy and financial uncertainty, instability and unpredictability; the main risks to the US economy are less organic than political, external and financial; and the risks of a policy mistake and/or market accident are increasing.
All of this calls for well-constructed tail protection and readily available cash to exploit the possibility of subsequent technical overshoots.