What is this Market Rally Telling Us?


Our hearts and prayers go out to the families and friends of those murdered and maimed in Nice, France last night during their celebration of Bastille Day.

Since BREXIT, US equity markets have come roaring back and then some. Increasing confidence that the Fed will pause their interest rate increases, a stronger-than-expected jobs report in the US on Friday, and the speedy transfer of power in Great Britain to Theresa May as Prime Minister have all added to the optimism driving stocks higher. The S&P 500 has had four record-high closes this week, yet other indexes have not, notably the Nasdaq, which remains almost 4% below last year’s high. It means that most stocks, and significantly many that have driven our economy of late (technology) remain off their highs.

While stock gyrations up and down dominate the news, financial and global, there is more wisdom in discerning what the bond markets suggest with their price swings. After all, stock markets can move substantially 1-5% on a single news event that may affect a quarter or two, but bond prices are much more muted as most investors are looking well into the future – 10, 20, and 30 years into the future. Last Friday, the 30-year Treasury yield hit an all-time low as stocks rallied. So far this year, our 7-10 Year Treasury Index is up 7.25% compared to the S&P 500’s 5.9%.

Bond investors are likely focused on the potential for uncertainty, at least near term in trade should Mr. Trump be elected, they see BREXIT as a net negative for economic growth in Europe and the UK, and China’s apparent failure to slow their growth so that demand can catch up are all warning signs for the global economy.

The Fed decided to hold interest rates steady last month as economic reports leading up to that meeting had been more negative than positive capped by a shockingly low jobs report for May and the UK vote on whether to remain in or exit the European Union loomed. Is the Fed finished for the year, or are more rate hikes looming?

Jan Hatzius, Goldman Sachs’ chief economist wrote on Tuesday, now that many of the uncertainties preceding the Fed’s last meeting have cleared, “he suggests the markets now may be unduly optimistic in expecting just a single Fed rate hike and too pessimistic in their assessment of the economy, especially after the “blowout” 287,000 jump in June non-farm payrolls reported last Friday. Payrolls are growing at a 150,000-175,000 monthly clip — a strong pace with the economy near full employment with a jobless rate of 4.9%, and arguably stronger than 225,000 a month with a 6%-7% unemployment rate, he suggests.”

Wages and prices also have picked up, Hatzius continues, with Goldman’s pay tracker based on various measures accelerating to a 2.9% annual rate from the 2% pace that prevailed from 2010 to 2014. Forward inflation measures, both from break-even rates from Treasury Inflation Protected Securities and survey measures, show a moderate rebound in the past month or so.” Hatzius suggests the July 27 Federal Open Market Committee meeting offers the possibility of sending a message that a rate hike could be coming this year.

According to Barron’s the futures market doesn’t see any Fed rate increases for more than a year. Only by September 2017 does the probability of a hike exceed 50%, according to Bloomberg’s analysis. They go on to point out “a September hike would be a politically adroit move to maintain its appearance of nonpartisanship. The Nov. 1-2 meeting would come a week before Election Day. The next FOMC meeting is Dec. 13-14, which would be a year after the Fed’s initial hike, to 0.25%-0.5%, and probably would be the next most likely candidate.” The market does not currently expect a rate hike this year.

Given all the economic uncertainties around the world and the fact that most of the leading economies’ central banks continue to hold rates near or below zero, optimism is premature. Stocks have corrected 10% on two occasions during the past 12 months. But markets don’t have to collapse in order to correct overpricing. They can correct in time, meaning stock prices stall for a time until earnings catch up. Today the Wall Street Journal reminds of the “rotational bear market” of 1994 in which various sectors of the market corrected but the S&P 500 remain in a tight trading range as interest rates increased by 2%.

On balance, the rally is probably mostly snap-back from a short-term over-sell due to BREXIT and a flurry of negative US economic data. Calm and a greater sense of clarity have returned and stocks have done what they do – they have reacted – this time positively. But bonds, looking toward the longer term, continue to suggest we are not heading for significant economic and stock market improvement any time soon.