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Rates will rise. Markets won’t.

Brouwer & JanachowskiDecember 4th 2015

The November payrolls reported 211,000. That's enough for a mid-month rate rise of about 25bps. The Fed wants to raise rates. They believe employment is at equilibrium and inflation under control. But neither is correct. To repeat: employment growth in the post 2009 period has been way below past cycles and with an expanding work population. So either people don't want to work, are aging or the U.S. job machine is broken. We think it's not the first, a bit of the second and a lot of the third. Consider this:

  • 10% of new job entrants are unemployed
  • Nearly 50% of the new jobs are for those 55 and over in retail services, which is not a job to be in with all-conquering Amazon.
  • The number of hours worked fell
  • The number of dropouts fell but part-time employment rose by 580,000

Put all this together and you get a struggling workforce with minimal wage gains. But the market felt this was in the range. Stocks rallied a bit. Treasuries didn't move.

Last point on this. Chairperson Yellen gave a bizarre explanation of the need to raise rates on Wednesday saying that the “natural” (i.e. the interest rate the economy settles at) rate had fallen, that the models suggested 0% and negative rates but that they don't want to delay raising rates. Get that? Me neither.

Meanwhile in the ECB…

Announced lower, more negative deposit rates extended QE by six months into 2017 and lowered its inflation forecasts. This was considerably less dovish than the market expected, showing again, that central bankers are rarely hired for their communication skills. We think this will keep equities going for a while and markets rallied after initially falling.

Credit

We are looking at the credit cycle. This graph shows the increase in spreads for investment grade and high yield bonds. The bigger the spread over Treasuries, the weaker the market.

hyigspeaddsfredgraph

What's going on? Three things:

  1. The spike in large M&A deals means that companies are taking on more debt to finance takeovers.
  2. The credit cycle is linked to the profits cycle and that began to flatten in the third quarter.
  3. Banks, big borrowers at the best of times, face ever higher capital requirements and lower growth.

Bottom Line: We will probably trend flat for the rest of the year in most markets. We think the rate rise is priced in but it’s new ground for central bankers, the bond market and portfolio managers. So wait.

Christian Thwaites, Brouwer & Janachowski, LLC

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