The markets have spent the entire year debating with each other over whether the Fed would normalize monetary policy this year or not. Most of the investors who believed it would happen focused in on the September Fed meeting as the most likely time frame for the first post-Crisis rate hike. As we draw closer and closer to that meeting, which now stands just a little over a month away, markets are continuing to ebb and flow as each day is met with new data that is interpreted every which way but Sunday.
Last week was no exception. And while I think most of last week was much ado about nothing, there are some key things to point out and make sure that you have some context.
I suspect the Fed is concerned about the US Dollar, China, oil, US consumer data to name a few. However, at this point they really can’t come out and publicly admit these things. In addition to not being able to admit what keeps them up at night, the Fed also can’t come out and say that they are going to hike rates at the September meeting. They run the risk of consumer data and labor data falling off a cliff and then having to back pedal.
However, I saw two clues in last week’s Fed statement that all but assured a rate hike in September.
First, the Fed referred to the recent job gains as "solid". This is an upgrade from June where the Fed had noted that job growth had picked up.
The second clue was in the part of the statement that dealt with the labor market. Fed officials stated that they wanted to see "some additional improvement."
Keep in mind that weekly initial unemployment claims have fallen to new lows, momentum in the labor market remains intact and the Fed acknowledged that the underutilization of labor has diminished. This means that if there are no significant disappointing surprises in the next two employment reports that will be released before the Fed meets again, a hike will be delivered in September.
We also received a couple of “market moving” pieces of data last week.
I say market moving because markets did in fact respond to these two data points. However, neither data point told us anything we didn’t already know and neither data point shifted the landscape for the Fed’s plan to normalize monetary policy.
The first was the first look at US Q2 GDP, which came in at 2.3%. This was a significant acceleration from Q1 GDP’s 0.6% growth rate, which incidentally was revised higher from earlier estimates.
As I discussed in last week’s commentary, you didn’t need to wait until the last week of July to know that US growth had accelerated from Q1 to Q2, the markets had already told us.
US economic growth accelerated in large part due to consumer spending and exports. Disposable personal income also accelerated higher, which could lead to even stronger consumption in the months ahead. These positive points were offset by the weakest business spending in over three years.
All in all, the Q2 GDP report seems to point to an all systems go for the Fed to raise rates. This is in contrast to the only other data point of any significance last week, wage growth. The latest wage growth data showed just a 2% year-over-year increase and only a 0.2% bump quarter over quarter. This was the worst wage growth data since records for this report began back in 1982.
It also showed a significant deterioration at the margin from Q1’s 0.7% quarter over quarter growth rate. The abysmal wage growth data doesn’t derail a September rate hike. However, the weakness of that report will put even more pressure on this week’s monthly jobs numbers to show that the labor market is still very firm and that any slack is being absorbed.
As readers of TWR know, and as I reiterated in last week’s commentary, I have a couple of proprietary indices that do a good job of telling me in real-time whether US economic growth is accelerating or not.
In addition to those indices, I, along with everyone else in the known world, keep an eye on the US yield complex for both an insight into US growth expectations as well as rate expectations. However, in recent weeks, the US Treasury market has been giving mixed signals.
While it appears that US economic growth accelerated higher in Q2, the Treasury market is unconvinced that Q2’s GDP print is enough to bring a rate hike in September.
If you pay attention to the 10-year Treasury, then the likelihood of a September rate hike is debatable. 10-Year Treasuries broke out to new 8-month highs in the middle of June, traded sideways for a couple of months and have shown renewed weakness over the last 2 weeks.
Juxtapose this price behavior with that of the 2-year Treasury. The 2-year Treasury, which is the most sensitive to the market’s rate expectations, has been getting tighter for the last few weeks and closed last week near recent highs, signaling that a rate hike is imminent.
This struggle within the Treasury market is happening because neither side can show enough evidence to move the opposite side off of their views. The US economy is exhibiting moderate growth, the labor market is continues to be firm but inflationary readings, while improving, are being held back by concerns over a global slowdown, originating in China.
The Week Ahead
As I mentioned earlier, the most important data points this week are the monthly US jobs reports. The Fed statement called job growth "solid," and appeared to lower the bar for a hike by modifying the continued improvement in the labor market with the word "some."
If the jobs reports show that the US economy continued to generate 200k+ jobs in July, I’d say that the “some improvement” mandate will be met. The other reason the employment report has added significance is that a positive report will neutralize the effect of last week’s lousy wage growth numbers.
But keep in mind that contrary to how markets responded to the wage growth report, it is not a necessary precondition for a rate hike. Likewise, an acceleration in average hourly earnings growth would be helpful, but is not necessary for the Fed to hike rates.
The other two reports of interest will be the consumer spending numbers due out at the beginning of the week along with the latest auto sales report. I would be careful trading all US based markets this week, namely equities, USD and US yields or fixed income. All of these are prone to over-reaction if we get jobs numbers that lead the markets to believe that a Fed rate hike in September is no more likely.