Sweet And Sour

Yes, I understand that it is an absolute blast to be long stocks when they are ripping higher. Everyone has fun, everyone feels wealthy, and all it took was for the Fed to defer a statement on the taper plan for at least a couple of months. For equity folks, that was equivalent to sounding the “all clear” signal to keep the party going for another couple of months. Add to that great news the fact that the ISM manufacturing index unexpectedly leapt today to two-year highs (see chart, source Bloomberg, below), and you have the possibility of good growth, with a supportive Fed. It isn’t that surprising that in the short term the equity folks are happy and the bond folks are a bit concerned.

But the worst threat to stocks isn’t the taper, it isn’t an incipient slowdown in China, and it isn’t the fact that margins appear to be compressing. It’s that they will, some day, face competition for investment dollars from interest rates, commodities, real estate, and all of those other things that haven’t been exciting to invest in for a while.

Ten-year interest rates at 2.70% are not an exciting investment, but they are definitely more exciting than 1.60% rates were. However, you don’t really need to think about whether marginal investment dollars will flow to bonds since rates are 110bps higher now. You know that, no matter what the yield, more investment dollars are going to be flowing to fixed income going forward.

How do we know this? We know it because the Fed isn’t going to be buying $85bln per month, at some point in the not-too-distant future. So we know that, even if the Fed doesn’t sell, the bond market will be soaking up another $85bln of investment dollars compared to what it has been doing during QE3. And those dollars will need to come from somewhere. After all, this is just the ‘portfolio balance channel’ in reverse. The Fed pushed risky markets higher by buying all the safe stuff, so as to force investors to move out the risk spectrum. By taking away the “safe” alternatives, in other words, the Fed substituted for “animal spirits” in the market. (I discussed and illustrated this back in January.)

The opposite also occurs, though. When the Fed steps out, some investors will buy those “safer” investments at the higher yields where those markets clear. Those investors will be coming out of stocks, mainly. By substituting for animal spirits, the Fed pushed the stock market higher when investors didn’t feel much like pushing it there. And, once they start to taper that policy, they need investors with real animal spirits to step in and take risky positions in stocks because they want to.

The head-scratcher for me is, why would I want to take a risky position in stocks now, when interest rates and in particular real interest rates, are higher…if I didn’t want to take that position before? Does growth suddenly look that much better?

I ought to reiterate here that I still think a bond rally is due, despite today’s shellacking in a fairly illiquid-seeming market. I will change that view if 10-year yields rise another 5-10bps, however. I frankly think that while Bernanke likely wants to take the first step towards tapering while he is still Chairman – since it’s the polite thing to do to take the riskiest step of unwinding his policy before the next Chairman is forced to do it – I doubt he wants to get so far down the tapering road that the next Chairman feels locked in to a certain course of policy. So I suspect we will not see as much tapering this year as the market expects. Investors clearly thought we would get some indication about tapering at this meeting, and we didn’t. Bond folks know we will, eventually. Equity folks also know we will, but they all think they can get out as soon as the Fed gives the signal.

The problem, of course, is that some investors won’t wait for the explicit signal. To be fair, it has been a losing trade to be early on the Fed taper story, but that just means the ultimate comeuppance is going to be worse.

There is a ton of data due out on Friday, but my attention will not be on the Payrolls figure (Consensus: 185k). It is perhaps frightening to think about this, but Payrolls in the neighborhood of 200k is about all that we can expect. The chart below (Source: Bloomberg) shows the BLS Nonfarm Payrolls statistics along with a 24-month moving average. Ignore the swings from month to month. Instead, notice that in the expansion in the mid-2000s the 2-year average never got above 200k, and even in the robust expansion of the late 1990s the average was only about 250k (and we’re not about to have a robust expansion any time soon!). So, whether you like it or not, 200k per month is about all you’re going to get.

The Unemployment Rate is expected to decline back to 7.5% after rising to 7.6% last month. And again, here, the rate of decline in the Unemployment Rate is about as fast as you’re going to get it (see chart below, source Bloomberg). In fact, if anything the decline in the ‘Rate is slightly faster than in recoveries past, although as has been well documented the unemployment rate is much higher if you discount the increased prevalence in this recovery of part-time work.

So, on growth the sad truth is that we have been waiting for economic improvement, but none is coming. This is about as good as it is likely to get, economically speaking (at least, in terms of the pace of improvement, though with time this will pull the Unemployment Rate gradually lower).

Indeed, much faster growth would likely incline the Fed to taper faster, and even to consider additional tightening measures. And much slower growth would probably dampen the rather ebullient earnings estimates of the sell-side analysts. The dividend yield is less than 2% with inflation-linked bonds paying around 0.5%. So I won’t be looking at the numbers very closely. We are already in the sweet spot. What I am going to be looking for, tomorrow and going forward, is any sign that investors are getting a sour taste.