U.S. Labor Market Seriously Injured

Note: Also posted on Seeking Alpha. It can be found here.

April FOMC Meeting Minutes: “It likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.”

Last Friday: 38K jobs created in May, the fewest since September 2010. Way way lower than 123K jobs gained (that number is revised….hold your breath) in April. Way way lower than 159K gain expected.


Labor market was seriously injured in May. The United States added only 38,000 new jobs, the fewest in almost six years. Things get worse. Prior two months reading were revised lower by 59,000. There were 123,000 jobs added in April down from initial estimate of 160,000. Nonfarm payroll for March was revised to 186,000 from 208,000.

Total Non-Farm Payrolls - Monthly Net Change (In Thousands)
Total Non-Farm Payrolls – Monthly Net Change (In Thousands)

Yet, unemployment rate surprisingly dropped by 0.3% to 4.7%, the lowest since November 2007. Hold on a second. How can unemployment rate drop so much if employment decreased so much? More people left the labor force, as confidence in the labor market is cooling down.

The labor force participation rate decreased by 0.2% to 62.6%, near 38-year low, unwinding about two-thirds of the rise between last September and March. A record 94,708,000 Americans were not in the labor force in May, 664,000 more than in April.

Unemployment Rate and Labor Force Participation Rate "Death Cross"
Unemployment Rate and Labor Force Participation Rate “Death Cross”

The report has evaporated the chance of a rate-hike this month from the Federal Reserve. Before the report, the federal funds futures were pricing in 55% chance of a rate-hike. Now, that is less than 5%.

Federal Funds Futures Source: @MktOutperform (Twitter)
Federal Funds Futures
Source: @MktOutperform (Twitter)

The next probable rate-hike prediction is December. As I mentioned in early January, the Federal Reserve will lower back rates this year. Let’s dig deep into the jobs report.

About 35,000 job losses can be connected to a 45-day Verizon strike, which began on April 13. The workers returned to work on Wednesday, June 1st, after unions reached a deal with the telecommunications company on compensation and job security.

Since they were not working and was on a strike, they were counted as unemployed. Without the “Verizon strike effect,” May nonfarm payroll would have shown 73,000 gain, still way below from the prior month and expectations.

Information services employment, which Verizon workers would fall under, declined by 34,000 jobs in May, the first decline since November 2015. The Bureau of Labor Statistics (BLS) even highlighted the impact of the strike, “employment in information decreased due to a strike.” “About 35,000 workers in the telecommunications industry were on strike and not on company payrolls during the survey reference period,” said BLS in the report.

This is not the first time Verizon workers went on a strike. In both 2000 and 2011, information services employment dropped as Verizon workers demanded more benefits. The month after the strikes, the sector’s employment numbers rebounded.

Verizon Strikes & Information Employment Source: @M_McDonough
Verizon Strikes & Information Employment
Source: @M_McDonough (Twitter)

These 35,000 Verizon workers will be added back to the June’s nonfarm payrolls.

The agreement between the unions and the company gives Verizon workers 10.9% increase in pay over four years (contract expired on August 3, 2019), as well as other benefits. That pay raise is way more than stagnant wages across the country.

Average hourly earnings rose by 5 cents (0.2%) to $25.59, following 9 cents (0.4%) increase in April. On a year-over-year (Y/Y) basis, the wage growth was flat for two months, growing by 2.5%.

Average Hourly Earnings and 12-Month Percentage Change "Death Cross"
Average Hourly Earnings and 12-Month Percentage Change “Death Cross”

Unemployment at 4.6% is within the range the Fed considers “full employment.” The average unemployment rate from 1948 (oldest data I could find) to last month is 5.8%. This leads me to believe the unemployment rate is below its natural rate, 5.8%. Then, why is not inflation higher?

According to Phillips curve, inflation should be higher. Inflation has been hovering around 0% and 1% since the end of 2014. So, why is the Phillips curve not really working?

Phillips Curve (Inflation and Unemployment Rate)
Phillips Curve (Inflation and Unemployment Rate)

If there’s a recession later this year or next year (as some people are forecasting) and the inflation rate is the same as now, we will have a deflationary problem. This time, the deflationary problem will be much worse than they were before. At this time, I am not forecasting anything on recession. If there is one, it will be very interesting how the central banks react to the deflationary pressures, considering the fact that they are running out of ammunition.

I believe Phillips curve is not really working today due to unemployment engineering (like companies do with non-GAAP) and globalization. Workers should not be counted as unemployed because they didn’t look for work in the past four weeks. Instead, it should be three months or more. It gives them more time to think and flush out their savings, if they even have one. Such discouraged workers should be included in the calculation process of unemployment.

Mostly important, globalization has played a big part in the crisis of Phillips curve. Since the financial crisis and light-speed innovation of technology, many companies found ways and more ways to reduce the costs. Since they are battling for customers, they are reducing their prices, keeping inflation low. The trade agreement, Trans-Pacific Partnership (TPP), will keep or even lower inflation further.

The countries included in TPP (China is excluded) account for 36.2% of global economic output and 25.6% for world trade. By eliminating taxes on exports, companies with intense competition, will reduce their prices further. For example, TPP eliminates import taxes up to 70% on U.S. automotive product exports to TPP countries.

The prices of drugs, on the hand other, will continue to increase. TPP increases the protection of drug patents and copyrights, reducing the availability of cheap generics.

Back to the jobs report. Private sector added only 25,000 jobs, the fewest since February 2010. April’s private sector gain was revised down to 130,000 from 171,000. March’s gain was slightly revised down to 167,000 from 184,000. Constructions payrolls dropped by 15,000, the most since December 2013 and the second consecutive month of decline.

The goods producing sector, which includes mining, manufacturing, and construction, shed 36,000 jobs, the most since February 2010. Mining employment continued its downward trend as plunging oil prices penetrated the operations of energy companies, shedding 10,000 jobs in May. Mining employment have dropped by 207,000 since peaking in September 2014, with three-quarters of the losses in support activities.

Temporary-help service jobs shrank by 21,000 and are down by 64,000 so far this year.

Employment and Earnings by Industrial Sector. Percentage of Labor Force sorted: From the highest to lowest. Green colors: Highest in the column Red colors: Lowest in the column
Employment and Earnings by Industrial Sector.
Percentage of Labor Force sorted: From the highest to lowest.
Green colors: Highest in the column
Red colors: Lowest in the column

Retail employment rose 11,400 (Shopping for summer?) after losing jobs in April for the first time since December 2014. Health care added the most jobs, with 45,700. Over the year, health care jobs jumped by 487,000 (Thanks, Obamacare?).

Diffusion index – which measures the breadth of employment across the private sector – collapsed to 51.3%, the lowest since February 2010. A reading of 50 represents that as many industries gained employment as lost employment. If it’s 0, employment of all industries decreased. If it’s 100, employment of all industries increased. That is down from 53.8% in April and 56.3% in March and from the recent peak of 71.2% in November 2014.

Total Private Employment: 1-Month Employment Change and 1-Month Diffusion Index
Further, the number of people employed for part time for economic reasons (involuntary part-time workers), climbed by 468,000 to 6.4 million, the highest since August and the largest jump since September 2012. This level, in addition to other numbers above, suggests slack still in the labor market. It is still high by historical standards.
Part-Time Employment Level for Economic Reasons
Part-Time Employment Level for Economic Reasons

These workers are included in the alternative measures of underutilization (U-6) that remained unchanged at 9.7% in May.

There are nearly 1.9 million workers who have been unemployed for more than 26 weeks, down from 2.1 million in April. It’s the lowest since July 2008, but is still high by historical standards.

Unemployed over 27 weeks
Unemployed over 27 weeks

Three-month average of total nonfarm is down to 116,000 from 181,000 in April. It’s the lowest since July 2012 and is down from 203,000 three-month average during he same period last year. The three-month average of total private is nosedived to 107,000 from 173,000 in April.

The Federal Open Market Committee will meet on June 14-15. They will keep rates on hold, unless they don’t listen to the market like in December. Again, I continue to believe the Fed will lower back rates this year.

The labor market remains in hospital with serious injuries. 

Reactions to the jobs report:

U.S. Dollar (greenback):

U.S. Dollar ("/DX" on thinkorswim)
U.S. Dollar (“/DX” on thinkorswim)

 Gold:

Gold ("/GC" on thinkorswim)
Gold (“/GC” on thinkorswim)

Houston (Fed), We Have A Problem (Problems) – Part 2/2

In the previous article, Houston (Fed), We Have A Problem (Problems) – Part 1/2, I addressed two risks (growing monetary policy divergence and emerging markets)  that will force the Fed to “land” (lower back) rates this year. I will address more risks here.

One huge risk that I will not address here, but will address in a future article is “lack of liquidity”. While I was doing research, I came across more information that I expected. I’m still getting more information and I believe it will be a great article. I will give a sneak peek of the article in the bottom of this article.

Junk Bonds, Credit Spreads, Energy, Manufacturing, Earnings Decline:

Earlier last month (December 10, 2015), Third Avenue’s Focused Credit Fund (FCF), a large mutual fund specializing in risky, high-yielding bonds, announced it would block investor redemptions, “no further subscriptions or redemptions will be accepted.” In mid-2014, they had $3.5 billion assets under management (AUM). As of December 31, 2015, they only had AUM of $660.67 million, as investors rushed to get their money back because of weakness in the junk bond market.

Now, investors’ money are being held hostage. “The remaining assets have been placed in a liquidating trust”, said David Barse, CEO of the firm, as the investor requests for redemptions and the “general reduction of liquidity in the fixed income markets” made it impossible for the fund to “create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders.”

The process is a pain in the ass, “Third Avenue anticipates that the full liquidation process may take up to a year or more.” Again, investors’ money are being held hostage.

This events highlights the danger of “over-investments” into risky areas, high levels of corporate debt, AND the lack of liquidity (will be addressed in a future article). With interest rates hovering around 0 (well, before the rate-hike in December), U.S. companies have rushed to issue debt.

Investors who poses a higher risk appétit can find junk bonds, yielding higher interest rates, to be “useful” for their style and capacity of investment. More rewards for more risks, right?

As the global economy continues to struggle, namely China and emerging markets, yield on junk bonds have been increasing since they are a higher chance of defaulting.

Rising interest rates adversely impact bond prices, pushing their yield of the bond higher (inverse relationship). While increase in rates does not largely affect junk bonds since they have a higher coupon (yield) and shorter maturities (shorter maturity means less price sensitivity to rates), current junk bond market combined the impacts of a stronger dollar and low commodity prices can be extremely adverse and dangerous.

High-yield debt yields, as represented by Bank of America Merrill Lynch U.S. High Yield Master II Effective Yield, have been increasing since mid of last year. It rose from 5.16% (June 23, 2014) to current 9.23%. That’s whopping 78.88% increase, representing the growing risks of junk bond market.

BofA Merrill Lynch U.S. High Yield Master II Effective Yield Source: retrieved from FRED, Federal Reserve Bank of St. Louis
BofA Merrill Lynch U.S. High Yield Master II Effective Yield
Source: retrieved from FRED, Federal Reserve Bank of St. Louis

 

According to Lipper, investors pulled out a total $13.88 billion from high-yield funds in 2015, with $6.29 billion in December alone. As redemptions increase, funds may suffer as high-yields are harder to trade due to its lack of liquidity (will talk more about the major risk of illiquidity in a future article) and funds may have to take an action like the Third Avenue did.

Credit spreads (difference in yield between two bonds of similar maturity but different credit quality) are widening, which possibly signals a wider economic trouble ahead. Widening credit spreads mark growing concerns about the ability of borrowers to service their debt. Not only borrowers will suffer, but also lenders since they lost money.

BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread, representing the credit spread of the high yield bond market as a whole, have been increasing the middle of 2014. It’s currently at 775 (7.75%) basis points (bps).

BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread is currently 1,804bps wide (18.04), a level of highly distressed territory. Credits are defined as distressed when they are trading more than 1,000bps (10%) wide.

BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread AND BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread Source: FRED Economic Data
BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread AND BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread
Source: FRED Economic Data

I believe it will continue to increase this year, reflecting the worsening of the credit conditions that would cause greater concern among investors and policymakers (Hi, Ms. Yellen. Time to reverse the policy?)

iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG), an index composed of U.S. dollar-denominated, high yield corporate bonds, is already down 1.39% year-to-date (YTD) and was down 10.58% in 2015, expressing the increasing uncertainty by the investors, as they pull back their money from high-yielding bonds/ETFs. The exposure of the index to CCC rated bonds, B rated bonds, and BB rated bonds, are 8.88%, 38.73%, and 50.25%, respectively. Stronger U.S. dollar and lower commodity prices are expected (and it will) to hurt the earnings of U.S. companies, increasing the chances of defaults, especially in energy.

iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG)
iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG)

The index’s energy exposure is 9.38%. Recently oil prices plunged to levels under $30. Energy companies borrowed a lot of debt during oil price boom, to increase production (so that they can gain more market share), are now being haunted by their own actions. A lot of energy companies are currently under an extreme pressure to make a dime, as oil prices plunge. According to law firm Haynes and Boone, 42 North American oil and gas producers filed for bankruptcy last year. Those 42 defaults account for approximately $17 billion in cumulative secured (over $9 billion) and unsecured debt (almost $8 billion).

2015 E&P Bankruptcy Filings Source: Law firm Haynes and Boone - Slide 5
2015 E&P Bankruptcy Filings
Source: Law firm Haynes and Boone – Slide 5

Out of those 42 bankruptcy filings, 18 of them come from Texas, a leading state in energy production. According to U.S. Energy Information Administration (EIA), Texas had a capacity of over 5.1 million barrels of crude oil per day and accounted for 29% of total U.S. refining capacity, as of January 2015, and accounted for about 29% of U.S. gas production in 2014.

In 2014, Texas gross domestic product (GDP) increased 5.2% year-over-year (Y/Y), the second greatest change in state GDP after North Dakota. Mining industry accounted for 1.25% increase to GDP, its largest contributor. Texas’s GDP accounted for 9.5% of U.S. total GDP in 2014.

The collapse of energy prices over the past several years are “fracking” down the Texas economy. The Dallas Federal Reserve’s general business activity index “collapsed” to -34.6 in January, the lowest reading since April 2009, when Texas was in recession. Same with company outlook index, it fell to -19.5 in January from -10.5 in December.

Texas Manufacturing Outlook Survey – General Business Conditions Source: Federal Reserve Bank of Dallas
Texas Manufacturing Outlook Survey – General Business Conditions
Source: Federal Reserve Bank of Dallas

The production index – a key measure of state manufacturing conditions – fell all the way from 12.7 in December to -10.2 in January. New orders index fell -9.2 in January from -7 in December.

Texas Manufacturing Outlook Survey – Business Indicators Source: Federal Reserve Bank of Dallas
Texas Manufacturing Outlook Survey – Business Indicators
Source: Federal Reserve Bank of Dallas

Employment Index, on the other hand, sharply dropped to -4.2 in January from 10.9 in December. Texas is a home to many energy giants, such as Schlumberger (NYSE: SLB), Halliburton (NYSE: HAL), Baker Hughes (NYSE: BHI), Exxon Mobil (NYSE:XOM), and ConocoPhillips (NYSE:COP). The companies slashed off tens of thousands of jobs over the past year and cut capex significantly, as the current stressed energy market heavily weighted on them.

In January 21, Schlumberger reported 38.7% decrease in fourth quarter revenue Y/Y, and net income declined substantially to a loss of $989 million, compared with profit of $317 million in the same period of 2014. Texas-based energy giant’s North American region 4th quarter revenue fell 54.79% to $1.9 billion from $4.3 billion in the same quarter of 2014. The company’s earnings announcement warned of a “deepening financial crisis in the E&P industry, and prompted customers to make further cuts to already significantly lower E&P investment levels. Customer budgets were also exhausted early in the quarter, leading to unscheduled and abrupt activity cancellations.” As a result of a weaker quarter and worsening conditions, they plan to lay off 10,000 workers, adding to already laid-off 34,000 workers, or 26% of its original workforce, since November 2014.

On Monday (January 25, 2016), Halliburton reported its fourth quarter earnings. Halliburton’s 4th quarter revenue fell 42% in Y/Y to $5.08 billion, including a 54.4% plunge to $2.1 billion in its North American region, which accounted for 42.4% of total revenue in 4Q.  On a GAAP basis, the Texas-based energy giant (and another one) reported a quarterly net loss of $28 million ($0.03 per share) compared with net income of $9.01 million ($1.06 per share) in the fourth quarter of 2014.

On Thursday (January 28, 2016), Baker Hughes reported a 48.85% decrease in fourth quarter revenue to $3.4 billion from $6.6 billion in the same period of 2014. On GAAP basis, the Texas-based energy giant (and another one) reported a quarterly net loss of $1 billion ($2.35 per share) compared with net income of $663 million ($1.52 per share) in the fourth quarter of 2014. Its North American region revenue fell 65.59% to $1.14 billion in the fourth quarter, compared with $3.30 billion in the fourth quarter of 2014.

Chevron Corp., (NYSE: CVX), California-based energy giant, posted its first loss since the third quarter of 2002 on Friday (January 29, 2016). It reported a fourth quarter loss of $588 million ($0.31 per share), compared with $3.5 billion ($1.85 per share) in the same period of 2014. During the same period, its revenue fell 36.5% to $29.25 billion from $46.09 billion.

Below is a graph by EIA, showing how the cost of debt service for U.S. oil producers has grown since 2012. In the second quarter of 2015, more than 80% of these producers’ cash flow went to service their outstanding debt, leaving very little cash to fund operations, to pay dividends, and to invest for the future. To adjust to those pains, the producers have significantly reduced capital expenditures.

Debt service uses a rising share of U.S. onshore oil producers’ operating cash flow Source: EIA
Debt service uses a rising share of U.S. onshore oil producers’ operating cash flow
Source: EIA

During the end of Q2 2015, oil prices were around $58. It’s currently at $38. Clearly, the situation has only gotten worse.

Both Exxon Mobil and ConocoPhillips will report its fourth quarter earnings next week.


I believe oil prices have hit bottom and it won’t break $27 this year.

Why do I say that?

I believe the market already priced in Iran’s entry into oil war. Recently, hedge fund bearish bets on oil were at all-time high (crowded trade). Crowed trade includes: a large numbers of participants who share similar beliefs and heavy short-term bag holders (speculators). I tend to take advantage of this types of situations.

Not only bearish bets on oil are at all-time high and not only I believe Iran is already priced in, but some OPEC countries, including Nigeria and Venezuela, already started calling for emergency meetings to try to cut production. I’m starting to believe that they can no longer handle the pain. While this is a political game – to gain and preserve more market share – it won’t last long enough to get oil breaking below $27. They can no longer bluff.

For many OPEC members, operating costs are around $30. With slowing global growth, they can’t afford to have even lower oil prices.

Conclusion: Oil has hit bottom and it won’t break below $27 this year. If you disagree with me, feel free to comment below.


Speaking of junk bonds, the energy sector makes up about a fifth of the high-yield bond index. Fitch Ratings forecast the US high yield energy sector default rate to hit 11% this year, “eclipsing the 9.7% rate seen in 1999.”

According to Fitch Ratings, at the beginning of December of last year, “$98 billion of the high yield universe was bid below 50 cents, while $257 billion was bid below 80 cents. The battered energy and metals/mining sectors comprise 78% of the total bid below 50 cents. In addition, 53% percent of energy, metals/mining companies rated ‘B-‘ or lower were bid below 50 at the start of December, compared to 16% at the end of 2014, reflecting the decline in crude oil prices.”

Not only energy companies will suffer, but also banks. The biggest U.S. banks – Morgan Stanley, Citigroup, Bank of America, Goldman Sachs, Wells Fargo, and JPMorgan Chase – have exposure to energy as part of their overall portfolios.

  • Morgan Stanley: Energy exposure assumed at 5% of total loans.
  • Citigroup: Energy exposure assumed at 3.3% of total loans.
  • Bank of America: Energy exposure assumed at 2.4% of total loans.
  • Goldman Sachs: Energy exposure assumed at 2.1% of total loans.
  • Wells Fargo: Energy exposure assumed at 1.9% of total loans.
  • JPMorgan Chase: Energy exposure assumed at 1.6% of total loans.

According to Fitch Ratings, exposure to energy sector were “cited as higher risk segments for the banks.”

The collapse in oil prices, strong U.S. dollar, and weakening global economy “crippled” manufacturers across the country. The Empire State manufacturing index fell to -19.4 in January from -6.2 in December, the lowest level since March 2009. The reading suggests manufacturing sector is slowing down and it raises questions about the outlook for the economy.

Manufacturing is very important to the U.S. economy. According to National Association of Manufacturers (NAM), there are 12.33 million manufacturing workers in the U.S., accounting for 9% of the nation’s workforce. Manufacturers recently contributed $2.18 trillion to the U.S. economy. “Taken alone, manufacturing in the United States would be the ninth-largest economy in the world.” according to NAM. For more facts and details, click here.

The manufacturing index have been below zero since July. Not only did the headline fell, but so did new orders index and shipments index. New orders fell 23.5 in January from -6.2 in December. Shipments fell -14.4 in January from 4.6 in December.

The Empire State Manufacturing Survey Source: Federal Reserve Bank of New York
The Empire State Manufacturing Survey
Source: Federal Reserve Bank of New York

Slump in new orders can shift the production into lower gear and possibly jeopardize jobs. The employment (number of employees) index continued to deteriorate for a fifth consecutive month. The weaknesses in the Empire State indexes suggests that the earnings of manufacturers are under pressure.

According to FactSet, the S&P 500 is expected to report a Y/Y decline in earnings of 5.7% for the fourth quarter. For Q4 2015, the blended earnings decline is -5.8%. A Y/Y decline in earnings for the fourth quarter will mark the first time S&P 500 has reported three consecutive quarters of Y/Y declines in earnings since Q1 2009 through Q3 2009.

For Q1 2016, 33 companies out of S&P 500, so far, have issued negative EPS guidance and 6 companies have issued positive EPS guidance.

Another drag on earnings can be the current inventories to sales ratio. Since early 2012, the ratio has been increasing.

Total Business: Inventories to Sales Ratio Source: Federal Reserve Bank of St. Louis
Total Business: Inventories to Sales Ratio
Source: Federal Reserve Bank of St. Louis

An increasing ratio is a negative sign because it shows companies may be having trouble keeping inventories down and/or sales have slowed. If they have too much of inventories, they may have to discount the products to clear their shelves, dragging on the earnings.

If you have any questions, feel free to contact me and/or leave comments below. Thank you.

Sneak peek of a future article that addresses one huge risk (lack of liquidity):

“With low liquidity in the bond market and increasing HFT transactions in it, the threat is real. Automated trades can trigger extreme price swings and the communication in these automated trades can quickly erode liquidity before you even know it, even though there is a very high volume. While liquidity in the U.S. bond market is high, it’s not high enough to battle the power of the technological progress.”

Houston (Fed), We Have A Problem (Problems) – Part 1/2

15 seconds and counting

12….11…10…9….IGNITION SEQUENCE START….6….5….4….3….2….1….0….ALL ENGINES RUNNING….LIFTOFF….WE HAVE A LIFTOFF!

The Fed finally raised rates after nearly a decade.  On December 16, the Fed decided to raise rates – for the first time since June 2006 – by 0.25%, or 25 basis points. It was widely expected by the markets and I only expected 10bps hike. Well, I was wrong on that.

The Federal Open Market Committee (FOMC) unanimously voted to set the new target range for the federal funds rate at 0.25% to 0.50%, up from 0% to 0.25%. In the statement, the policy makers judged the economy “has been expanding at a moderate pace.” Labor market had shown “further improvement.” Inflation, on the other hand, has continued to “run below Committee’s 2 percent longer-run objective” mainly due to low energy prices.

Remember when the Fed left rates unchanged in September? It was mainly due to low inflation. What’s the difference this time?

In September, the Fed clearly stated “…surveybased measures of longer-term inflation expectations have remained stable.”

Now, the Fed clearly states “…some survey-based measures of longer-term inflation expectations have edged down.”

So…umm…why did they raise rates this time?

Here is a statement comparison from October to December:

Fed Statment Comparation – Oct. to Dec. Source: WSJ
Fed Statement Comparison – Oct. to Dec.
Source: WSJ

On the pace of rate hikes looking forward, the FOMC says:

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

They clearly stated one of the things they look for, which is inflation expectations. But, they also did state that “inflation expectations have edged down.”

It seems to me that the Fed did not decide to raise rates. The markets forced them. Fed Funds Futures predicted about 80% chance of a rate-hike this month. If the Fed did not raise rates, they would have lost their credibility.

I believe the Fed will have to “land” (lower back) rates this year, for the following reasons:

  • Growing Monetary Policy Divergence

On December 3, European Central Bank (ECB) stepped up its stimulus efforts. The central bank decided to lower deposit rates by 0.10% to -0.30%. The purpose of lower deposit rates is to charge banks more to store excess reserves, which stimulates lending. In other words, free money for the people so they can spend more and save less.

ECB also decided to extend Quantitative Easing (QE) program. They will continue to buy 60 billion euros ($65 billion) worth of government bonds and other assets, but until March 2017, six months longer than previously planned, taking the total size to 1.5 trillion euros ($1.6 trillion), from the previous $1.2 trillion euros package size. During the press conference, ECB President Mario Draghi said the asset eligibility would be broadened to include regional and local debt and signaled QE program could be extended further if necessary.

ECB might be running out of ammunition. ECB extending its purchases to regional and local debt raises doubts about its program.

Not only ECB is going the opposite direction of the Fed. Three weeks ago, Bank of Japan (BoJ) announced a fresh round of new stimulus. The move was hardly significant, but it is still a new round of stimulus. The central bank decided to buy more exchange-traded fund (ETF), extend the maturity of bonds it owns to around 7-12 years from previously planned 7-10 years, and increase purchases of risky assets.

I previously stated in “Central Banks Smash: No Growth, No Inflation“,

The extensions of its QE are beginning to become routine or the “new normal”.

Japan's ETF Market - BoJ's holdings Source: Bloomberg
Japan’s ETF Market – BoJ’s holdings
Source: Bloomberg

The move by BoJ exposes the weakness of its past actions. It suggests the bank is also out of ammunition. Already owning 52% or more of the Japan’s ETF market and having a GDP-to-Debt ratio around 245%, it is only a matter of time before Japan’s market crashes. Cracks are already beginning to be shown. I expect the market crash anytime before the end of 2019.

So, what are the side-effects of these growing divergence?

For example, the impact of a US dollar appreciation resulting from a tightening in US monetary policy and the impact of a depreciation in other currencies resulting from easing in its monetary policies. Together, these price changes will shift global demand – away from goods and services produced here in the U.S. and toward those produced abroad. In others words, US goods and services become more expensive abroad, leading to substitution by goods and services in other countries. Thus, it will hurt the sales and profits of U.S. multinationals. To sum up everything that is said in this paragraph, higher U.S. rates relative to rates around the global harms U.S. competitiveness.

  • Emerging Markets

Emerging markets were trouble last year. It is about to get worse.

International Monetary Fund (IMF) decided to include China’s currency, renminbi (RMB) or Yuan, to its Special Drawing Rights (SDR) basket, a basket of reserve currencies. Effective October 1, 2016, the Chinese currency is determined to be “freely usable” and will be included as a fifth currency, along with the U.S. dollar, euro, Japanese yen, and pound sterling, in the SDR basket.

“Freely useable” – not so well defined, is it?

Chinese government or should I say People’s Bank Of China (PBOC), cannot keep its hands off the currency (yuan). It does not want to let market forces take control. They think they can do whatever they want. As time goes on, it is highly unlikely. As market forces take more and more control of its exchange-rate, it will be pushed down, due to weak economic fundamentals and weak outlook.

China, no need to put a wall to keep market forces out. Let the market forces determine the value of your currency. It is only a matter of time before they break down the wall.

In August, China changed the way they value their currency. PBOC, China’s central bank, said it will decide the yuan midpoint rate based on the previous day’s close. In daily trading, the yuan is allowed to move 2% above or below the midpoint rate, which is called the daily fixing. In the past, the central bank used to ignore the daily moves and do whatever they want. Their decision to make the midpoint more market-oriented is a step forward, but they still have a long way to go.

China saw a significant outflows last year. According to Institute of International Finance (IFF), an authoritative tracker of emerging market capital flows, China will post record capital outflows in 2015 of more than $500 billion. The world’s second largest economy is likely to see $150 billion in capital outflow in the fourth quarter of 2015, following the third quarter’s record $225 billion.

Ever since the devaluation in August, PBOC has intervened to prop yuan up. The cost of such intervention is getting expensive. The central bank must spend real money during the trading day to guide the yuan to the level the communists want. Where do they get the cash they need? FX reserves.

China’s foreign-exchange reserves, the world’s largest, declined from a peak of nearly $4 trillion in June 2014 to just below $3.5 trillion now, mainly due to PBOC’s selling of dollars to support yuan. In November, China’s FX (forex) reserves fell $87.2 billion to $3.44 trillion, the lowest since February 2013 and largest since a record monthly drop of $93.9 billion in August. It indicates a pick-up in capital outflows. This justifies increased expectations for yuan depreciation. Since the Fed raised rates last month, I would not be surprised if the capital flight flies higher, leading to a weaker yuan.

China Reserves Source: Capital Economics
China Reserves
Source: Capital Economics

Depreciation of its currency translates into more problems for “outsiders,” including emerging markets (EM). EMs, particularly commodities-linked countries got hit hard last year as China slowed down and commodity prices slumped. EMs will continue to do so this year, 2016.

The anticipation of tightening in the U.S. and straightening dollar put a lot of pressure on EM. EM have seen a lot of significant capital outflows because they carry a lot of dollar denominated debt. According to the October report from IFF, net capital flows to EM was negative last year for the first time in 27 years (1988). Investors are estimated to pull $540 billion from developing markets in 2015. Foreign inflows will fall to $548 billion, about half of 2014 level and lower than levels recorded during the financial crisis in 2008. Foreign investor inflows probably fell to about 2% of GDP in emerging markets last year, down from a record of about 8% in 2007.

Capital Flows to Emerging Markets, Annual Data Source: IFF
Capital Flows to Emerging Markets, Annual Data
Source: IFF, taken from Bloomberg

Also contributing to EM outflows are portfolio flows, “the signs are that outflows are coming from institutional investors as well as retail,” said Charles Collyns, IIF chief economist. Investors in equities and bonds are estimated to have withdrawn $40 billion in the third quarter, the worst quarterly figure since the fourth quarter of 2008.

A weaker yuan will make it harder for its main trading partners, emerging markets and Japan, to be competitive. This will lead to central banks of EM to further weaken their currencies. Japan will have no choice but to keep extending their QE program. And to Europe. And to the U.S.      DOMINO EFFECT

Why are EMs so important? According to RBS Economics, EMs have accounted for 50%-60 of global output and 70% of global economic growth each year since the 2008 crisis.

Emerging Markets Share of Global Economy Source: RBS Economics
Emerging Markets Share of Global Economy
Source: RBS Economics

Some EM investors, if not all, will flee as U.S. rates rise, compounding the economic pain there. Corporate debt in EM economies increased significantly over the past decade. According to IMF’s Global Financial Stability report, the corporate debt of non-financial firms across major EM economies increased from about $4 trillion in 2004 to well over $18 trillion in 2014.

Figure 3.1. Emerging Market Economies Evolving Capital
EM Corporate Debt and Market Cap. Source: IMF – Page 84

When you add China’s debt with EM, the total debt is higher than the market capitalization. The average EM corporate debt-to-GDP ratio has also grown by 26% the same period.

EM Corporate Debt (percent of GDP) - Page 84
EM Corporate Debt (percent of GDP) – Page 84

The speed in the build-up of debt is distressing. According to Standard & Poor’s, corporate defaults in EM last year have hit their highest level since 2009, and are up 40% year-over-year (Y/Y).

Corporate Defaults Source: WSJ
Corporate Defaults
Source: WSJ

According to IFF (article by WSJ), “companies and countries in EMs are due to repay almost $600 billion of debt maturing this year….of which $85 is dollar-denominated. Almost $300 billion of nonfinancial corporate debt will need to be refinanced this year.”

I would not be surprised if EM corporate debt meltdown triggers sovereign defaults. As yuan weakens, Japan will be forced to devalue their currency by introducing me QE which leaves EMs with no choice. EMs will be forced to devalue their currency. Devaluations in EM currencies will make it much harder (it already is) for EM corporate borrowers to service their debt denominated in foreign currencies, due to decline in their income streams. Deterioration of income leads to a capital flight, pushing down the value of the currency even more, which leads to much more capital flight.

Let IMF explain the situation in EM,

“Firms that have borrowed the most stand to endure the sharpest rise in their debt-service costs once interest rates begin to rise in some advanced economies. Furthermore, local currency depreciations associated with rising policy rates in the advanced economies would make it increasingly difficult for emerging market firms to service their foreign currency-denominated debts if they are not hedged adequately. At the same time, lower commodity prices reduce the natural hedge of firms involved in this business.”

According to its Global Financial Stability report, EM companies have an estimated $3 trillion in “overborrowing” loans in the last decade, reflecting a quadrupling of private sector debt between 2004  and 2014.

EM Corporate Bond Composition (Billions of U.S. dollars) - Page 86
EM Corporate Bond Composition
(Billions of U.S. dollars) – Page 86
Private Sector Debt to GDP (Percent - Page 11
Private Sector Debt to GDP
(Percent – Page 11

Rising US rates and a strengthening dollar will make things much worse for EMs. Jose Vinals, financial counsellor and director of the IMF’s Monetary and Capital Markets Department, said in his October article, “Higher leverage of the private sector and greater exposure to global financial conditions have left firms more susceptible to economic downturns, and emerging markets to capital outflows and deteriorating credit quality.”

I believe currency war will only hit “F5” this year and corporate defaults will increase, leading to the early stage of sovereigns’ defaults. I would not be surprised if some companies gets a loan denominated in euros just to pay off the debt denominated in U.S dollars. That’s likely to make things worse.

Those are some of the risks I see that will force the Fed to lower back the rates.  I will address more risks, including lack of liquidity, junk bonds, inventory, etc, in my next article. Thank you.

EXTRA: Market reactions,

EUR/USD:

EUR/USD - Hourly Chart
EUR/USD – Hourly Chart

USD/JPY:

USD/JPY - Hourly
USD/JPY – Hourly

10-Year Treasury Index:

10-Year Treasury Index (TNX on thinkorswim platform) - Hourly
10-Year Treasury Index ( “TNX” on thinkorswim platform) – Hourly

2-Year U.S. Treasury Note Futures:

2-Year U.S. Treasury Note Futures ( "/ZT" on thinkorswim platform) - Hourly
2-Year U.S. Treasury Note Futures ( “/ZT” on thinkorswim platform) – Hourly

October Jobs Report Strong: It Is Just One Report

On November 6 (Friday), jobs report for October had the winds of 120 miles per hour and blew everyone away. Non-farm payrolls showed 271,000 jobs were added in October, the most gain since December and a huge beatdown on expectations of about 185,000. It’s the best month for job growth so far this year. The report follows two consecutive months (August and September) of weak jobs growth below 160,000.

The total job gains for August and September were revised 12,000 higher. August was revised 17K higher to 153K from 136k, and September was revised -5K lower to 137K from 142K. Over the last 12 months, employment growth had averaged 230K per month, vs. 222K in the same-period of 2014. In 2014, average monthly payrolls was 260K. This year, it is 206K. Not only jobs gains for October were strong, but also unemployment and wages.

Total Non-Farm Payrolls – Monthly Net Change
Total Non-Farm Payrolls – Monthly Net Change

The unemployment rate dipped 0.1% to 5%, its lowest level since April 2008. Average hourly earnings rose by 9 cents an hour to $25.20. It rose 2.5% year-over-year (Y/Y), the best level since July 2009. For most of the “recovery”, wages has been flat. The increase in earnings is significant for two reasons. More money for employees means more spending (don’t forget debts), which accounts two-thirds of the economy. Second, wage growth might suggest that employers are having trouble finding new workers (should I say “skilled” workers) and they have to pay more to keep its workers and/or to get new skilled workers. This could draw more people back into the labor market, increasing the participation rate. Without the right skills, good luck.

Average Hourly Earnings and Average Weekly Hours
Average Hourly Earnings and Average Weekly Hours

The labor force participation rate remained unchanged at a 38-year (1977) low of 62.4%. The long-term decline in the participation rate is due to the aging of the baby-boom generation and loss of confidence in the jobs market. There hasn’t even been a rebound in participation rate of prime-age Americans (between the ages of 25 and 54).

Unemployment Rate + Labor Force Participation Rate

More than 122 million Americans had full-time jobs at the end of October, the highest since December 2007 (121.6 million).

Full-Time and Part-Time Employment

Immediately after the jobs report, the probability of a rate-hike in December lifted. Fed funds futures currently anticipates about 65% chance of a rate hike next month vs. about 72% immediately after the report and about 55% before the report.

Federal Reserve Chairwoman, Janet Yellen, lately has been saying that December’s Federal Open Market Committee (FOMC) meeting was “live” for a potential rate-hike. While this jobs report is positive, I believe it is too early to jump in on conclusions.

The policymakers should not be too quick to act on one report. In September, the Fed left rates unchanged mainly due to a low inflation. Inflation is still low and we will get a fresh look on Tuesday (November 17) when Consumer Price Index (CPI) is released.

In March, the Fed expressed worries about the strength of the U.S. Dollar, just after the greenback hit above $100 mark. The greenback then tumbled and has never recovered back to $100….yet.

US Dollar ("/DX" on thinkorswim platform) - Daily
US Dollar (“/DX” on thinkorswim platform) – Daily

Right after the jobs report, the dollar skyrocketed and was 40 cents away from hitting $100 mark. It’s currently at $98.88 and there is a very high chance it will go above $100 until December 15, the first day of FOMC meeting.

If the November job numbers does not surprise to the upside (released in December 4), inflation stays low, and the dollar keeps strengthening, I do not believe the Fed will hit the “launch” button for a rate-hike liftoff.

Market Reactions:

US Dollar ("/DX" on thinkorswim platform) - Hourly
US Dollar (“/DX” on thinkorswim platform) – Hourly
S&P 500 Index ("SPX" on thinkorswim platform) - Hourly
S&P 500 Index (“SPX” on thinkorswim platform) – Hourly