January 8, 2019
By far the biggest news recently – ignored by most financial media – is the collapse of Treasury bond yields. Currently, the 10-year Treasury bond yield is 2.67%, after hitting 2.55% intraday on Thursday, during a global flight to quality. This sharp drop in rates led Fed Chairman Jerome Powell on Friday to say that the Federal Open Market Committee (FOMC) is “prepared to adjust policy quickly and flexibly” if necessary. Translated from Fedspeak, Chairman Powell seems to be saying that he may have been too strong in his previous language about two rate increases in 2019. With short rates rising and long rates falling, an ultra-flat yield curve will prohibit the Fed from raising key interest rates. As I have repeatedly said, the Fed never fights market rates, so current Treasury yields are forcing the Fed to adjust its policy.
The financial media is citing slow economic growth in Asia and Europe for falling Treasury bond yields, but the answer is much simpler, namely a strong U.S. dollar. Specifically, international capital prefers to hide in strong reserve currencies with relatively high interest rates. U.S. Treasury bonds yield much more than equivalent securities in Japan, Britain, or the euro-zone. China’s interest rates yield more than the U.S., but the yuan has been weak due to the ongoing trade spat as well as slowing GDP growth, so global investors are less inclined to park their capital in the Chinese yuan. As a result, the U.S. dollar continues to be the preferred reserve currency, which should help to keep Treasury bond yields relatively low.
Naturally, lower Treasury bond yields also make the stock market much more attractive, especially since it is very easy to pick high-dividend stocks that yield more than the 10-year Treasury bond. Since most dividends are taxed at a maximum federal rate of 23.8%, while Treasury interest is taxed at a maximum federal rate of 40.8%, the stock market delivers more after-tax income for most investors. This puts a floor under the market as long as the S&P dividend yield is over 2% and Treasuries remain around 2.7%.
Another factor that I am still waiting for regulators to address is ETF Premiums/Discounts relative to Net Asset Value (or Intraday Indicative Value in Morningstar). Unfortunately, as volatility soared in the fourth quarter, ETF Premiums/Discounts rose dramatically and have not fully subsided to where they were in the third quarter. Algorithmic traders have been increasingly utilizing ETFs to trade big blocks of stocks, so it is crucial that ETF Premiums/Discounts subside to boost investor confidence, especially for nervous investors that may want to trade in and out of financial markets in the upcoming months.
The Friday Jobs Report (and the Fed) Lifted the Market on Friday
The biggest economic news last week was the December payroll report. First, on Thursday, the ADP private payroll report rose a robust 271,000 in December, substantially higher than economists’ consensus estimate of 178,000 and the highest monthly private job gain in almost two years. ADP also revised its November private payroll increase to 157,000, down from 178,000 previously estimated.
Then, on Friday, the Labor Department announced that a whopping 312,000 payroll jobs were created in December, substantially higher than the economists’ consensus estimate of 182,000. Interestingly, the unemployment rate actually rose to 3.9% up from 3.7%, due to more people entering the labor force as the labor participation rate rose to 63.1% in December, up from 62.9% in November.
Average hourly earnings rose 0.4% or 11 cents per hour, to $27.48 per hour in December. In the past 12 months, average hourly earnings are up 3.2% and are now running at the highest pace in a decade. The average workweek also rose 0.1 to 34.5 hours per week. The other positive detail was that the October payroll report was revised 10,000 higher to 274,000, up from 237,000 previously estimated. Overall, the December payroll data was an incredibly bullish signal for continued strong consumer spending!
On the downside, on Thursday, the Institute of Supply Management announced that its manufacturing index in December decelerated to a two-year low of 54.1, substantially below economists’ consensus estimate of 57.5. In November, the ISM manufacturing index was a robust 59.3 and almost all industries surveyed reported an expansion. However, only 11 of the 18 industries surveyed expanded in December.
Some components of the ISM survey were disturbing, especially new orders, which decelerated sharply to 51.1 in December, down from 62.2 in November. The production component, at 54.3, is also at the lowest level in over two years. Any reading over 50 still signals an expansion, so the economy is still growing, but the abrupt deceleration in growth rates of the ISM manufacturing index was truly shocking.
Finally, on Wednesday, The Wall Street Journal reported that shale oil wells drilled in the past five years are pumping less crude oil than forecasted, so crude oil prices subsequently firmed up last week. Despite overly optimistic forecasts for crude oil production, U.S. production continues to rise steadily. Seasonal demand is expected to rise as Spring approaches, so some of the volatility in the energy sector may subside soon as worldwide demand rises as the weather improves in the Northern Hemisphere.