Why the Federal Reserve Will Move Rates

Michael E. Lewitt

To say that markets are confused about when the Federal Reserve is going to raise interest rates is the understatement of the year.

The confusion is understandable. While the U.S. economy no longer needs crisis-era policies like zero interest rates and quantitative easing, the rest of the world is still struggling.

While some would argue that such policies are not the answer, central banks in Europe, Japan and China are doubling down on huge bond buying programs.

The question is whether the Federal Reserve will go its own way or allow weakness abroad to govern its next move…

What Federal Reserve Officials are Saying About a Move

A number of key Federal Reserve officials have been telling investors to keep their eyes on the ball at home. Mostly recently, St. Louis Fed President James Bullard told markets that they were ignoring warnings from the Fed that it planned to raise interest rates by the middle of the year unless economic data started weakening again.

This echoes the consistent message of Fed Chair Janet Yellen as well as that of her most important deputy, New York Fed Chair William Dudley.

The key data that the Fed is focusing on is jobs data and inflation data, both of which are holding steady.

The January jobs report, which was released Friday, was one of the strongest in months and included big upward revisions in the data for November and December. And while inflation remains lower than the Fed would like, this is almost exclusively due to the sharp drop in oil prices. Overall inflation is close to the Fed's target of 2% and would quickly hit that level if oil prices were to recover or wages start to increase. Accordingly, the Fed is quickly running out of excuses to delay raising rates beyond June.

The Bond Markets Read the Fed's Signals

Last week, markets seemed to pick up on that message. While stocks boomeranged all over the place and momentarily regained all of their 2015 losses before ending slightly in the red, bonds got pummeled.

Treasuries sold off four days in a row last week, their longest losing streak since last September. The iShares 20+ Year Treasury Bond ETF (TLT) dropped by a sharp 7.32 points or 5.3% on the week to close at $130.96, its lowest close since January 5.

The two-year Treasury yield, the most sensitive to the Fed's next move, saw its biggest one day jump since 2009, closing at 0.643% and signaling concern that the Fed could move sooner rather than later. After dropping from 2.173% to 1.669% from the beginning of the year through last Monday, its lowest level since May 2013, the benchmark 10-year Treasury yield spiked back up to close the week at 1.94%.

To keep this in global perspective, however, this yield still dwarfs those on 10-year German and Japanese bonds of 0.376% and 0.345%, suggesting that U.S. Treasuries are still much more attractive than foreign bonds and are unlikely to sell off much further.

In the bond futures pits, which provide the best real-time consensus on when the Fed will raise rates, traders increased their bets on a June rate hike from 14% on Thursday to 24% on Friday. Looking out further, futures traders were placing a 63% probability of the Fed raising rates by 50 basis points by September; a week ago the odds were under 50%.

For investors who had talked themselves into thinking that the Fed might sit out 2015, it was not a good week.

How the Government Numbers Support an Increase

If we look at the January jobs report, we can see that it is time for the Fed to let go and let the economy walk on its own two feet. Actually, that has been the case for a couple of years, but central bankers tend to be slow learners and markets have become spoiled by easy money. The U.S. produced 257,000 jobs in January, 267,000 of which came in the private sector. In addition, last year's jobs gains were revised upwards by 245,000 to 3,197,000.

Remarkably, last November shows the second biggest jobs increase of the 21st century with 423,000 new jobs added. The U.S. economy has now added an average of 336,000 new jobs over the last three months, an impressive showing by any measure.

There was also a 746,000 person increase in household employment and a huge 1.05 million increase in the size of the labor force, which led to an increase in the unemployment rate to 5.7% in January as the labor participation rate rose to 62.9%, off the lowest levels of the last 40 years.

U6, a broader measure that includes underemployed and underutilized workers, ticked up to 11.3%. Even better, after a 0.2% drop in hourly earnings in December, earnings rebounded by 0.5% month-over-month in January, the largest monthly gain since November 2008. This was partly due to higher minimum wage losses that went into effect in 21 states on January 1st.

Over the December-January period, wage growth was still sluggish but if the trend holds it could put upward pressure on inflation. This report may seems odd with mass layoffs occurring throughout the energy industry, but it for the moment it appears to increase the pressure on the Fed to hike rates sooner rather than later.

Equity Markets Are Less Certain

Stocks reacted calmly to the jobs report than the bond market after a volatile week of strong gains, spending most of Friday doing very little until seeing some profit taking late in the day. Stocks enjoyed a heroic week as oil prices rose by 7% to $51.69 per barrel, completing a 13% recovery over the past two weeks.

Stocks also ignored the unfolding Greek drama as Greece threatens Europe and Europe threatens Greece. Meanwhile, nobody talks about the fact that Greece is broke and can never repay its debts or survive economically inside the European Union unless Germany pays the bills forever.

On the week, the Dow Jones Industrial Average jumped by 659 points, or 3.8% to 17,824.29. The S&P 500 gained 3%, or 61 points, to 2055.47 and is now just 3 points shy of where it started the year. The Nasdaq Composite Index rose by 109 points or 2.4% to 4744.40.

A number of widely followed companies spiced up the week's earnings reports including Twitter Inc (NYSE: TWTR), whose stock soared by more than 16% on Friday after failing for once to disappoint investor and hedge fund favorite Gilead Sciences, Inc. (Nasdaq: GILD), whose stock dropped by 9.3% in the days after announcing terrific earnings and the payment of its first dividend after disclosing some pricing pressures on its franchise hepatitis-C drug. Other stocks like Alibaba Group Holding Ltd (NYSE: BABA) ($85.68 versus a high of $120.00) and Microsoft Corporation ($42.41 versus a high of $50.05) are well off recent highs after disappointing high investor expectations.

This is an extremely demanding stock market trading at historic valuations. It is also a stock market that is ignoring the negative economic signals being emitted by the commodity and bond markets. While the S&P 500 is trading at about 16x estimates for 2015 earnings, those earnings estimates are being steadily lowered based on the drop in oil prices and the negative effect of the strong dollar on corporate results.

Other measures that I cite often, including the S&P 500 Market Cap/GDP Ratio and the Shiller Cyclically Adjusted P/E Ratio, are also at all-time highs and far above their historical norms.

What applies to expensive stocks also applies to an expensive market: there is no margin for error and earnings misses are punished with sharp sell-offs.

Whether stocks can hold onto the gains they enjoyed last week remains to be seen particularly if sentiment builds that a Fed rate hike is imminent. Investors would do well to look for opportunities to hedge their positions…

Michael E. Lewitt

About the Author

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Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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