October 9, 2018

Federal Reserve Chair Jerome Powell said last Tuesday in a speech at the annual meeting of the National Association for Business Economics (NABE) in Boston that the U.S. economy is in the midst of a “remarkably positive” period, unprecedented in modern history. “This historically rare pairing of steady, low inflation and very low unemployment is a testament to the fact we remain in extraordinary times.”

New data from the Fed is now predicting that unemployment will remain below 4% through 2020 and that inflation will stay low, averaging around 2% during that time. This has never happened in modern history. The last time unemployment was that low for several years was in the 1960s and it ultimately triggered high inflation, but Mr. Powell and the Fed majority do not think that will occur this time.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Powell doesn’t believe inflation is going to jump anytime soon, even though the labor market is tight, and wages are rising at their fastest rate in 10 years, as labor markets tighten further. He argues that the Fed is aware of the risks and is doing a more active job of managing inflation expectations than in the 1960s.

Add to this mix the fact that stock buy-backs for 2018 may exceed one trillion dollars by November and that 2018 is also on track for record dividend hikes, and the picture for the U.S. stock market gets pretty bright heading into the end of 2018, even at these near-record levels.

The Bond Market Bends on Latest High Yields

This past week, the bond market heaved on the release of a single data point. The Institute of Supply Management (ISM) Non-Manufacturing (Service) Index is an index based on surveys of more than 400 non-manufacturing firms’ purchasing and supply executives, within 60 sectors across the nation. This index is valuable for providing insights into the business conditions in the service sector, which has gained importance because these non-manufacturing sectors account for a majority of the economy.

The ISM Non-Manufacturing Index provides significant information about factors that affect total output growth and inflation. When used alongside the ISM Manufacturing Report, the industry coverage between the two reports accounts for almost 90% of the GDP. When this index is increasing, the stock market should increase because of higher corporate profits. The opposite can be thought of the bond markets, which may decrease as the ISM Non-Manufacturing Index increases because of sensitivity to potential inflation. And this past week, bonds gave up some ground on the latest ISM readings.

Last Wednesday, the ISM Non-Manufacturing Index checked in at 61.6 for September (vs. a consensus 58.2% expectation), up from 58.5 in August. According to ISM, that is the highest reading since the inception of the index in 2008. The dividing line between expansion and contraction is 50.0. That means business activity is strong for the service-providing sector of the economy. Some details within the report:

  • The New Orders Index increased to 61.6 from 60.4.
  • The Employment Index jumped to 62.4 from 56.7, the highest reading since the inception of the Employment Index in 1997.
  • According to ISM, the past relationship between the Non-Manufacturing Index and the overall economy indicates that September’s reading corresponds to a 4.6% annual increase in real GDP.

Historically, the ISM Non-Manufacturing Index has been a low-impact report to market direction, but not this time around. In fact, when the headline crossed the tape at 10:00 am EST, the 10-year Treasury was yielding 3.10%. By 10:30 EST, the yield had spiked to 3.26%, representing a fresh three-and-a-half year high, which in turn led to the stock market rout on Thursday and Friday.

From the 20-year chart (below), the move was sudden and technically significant. Going back to 2000, when the yield on this cycle topped out at 6.9%, a straight line catching the tops shows last week’s up move to penetrate that sloping overhead line and butt right up against the long-term 200-week moving average that comes into play right at 3.25%. A break above this level could (and probably will, in my view) invite further technical-related selling by computer-driven program trading platforms.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Needless to say, this week’s inflation data in the form of the release of the Producer Price Index (PPI) and Consumer Price Index (CPI) for September, both of which are forecast to a modest increase of 0.2% for the month, will be closely watched. The recent rise in energy prices could factor big in the data, given that oil prices rose throughout the entire month of September, as per the chart below of WTI crude oil, which saw the WTI price top $75 per barrel last week before mild profit taking set in.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

So, while the chartists are waving caution flags of higher yields ahead, there is some limited evidence of widespread inflation to support an unwinding of the bond market. Growth outside the U.S. is anemic and U.S. bond yields are tantalizingly high relative to those of other developed nations. Even if the Chinese have reduced or stopped altogether their purchases of U.S. Treasuries, as evidenced by the lower bid-to-cover ratio (now at 2.4x, down from 2.8x), there are plenty of buyers of U.S. debt at current levels, supported by our rising GDP and a rising valuation of the dollar against nearly all other currencies.

Only time will tell if the Fed’s viewpoint pans out, but if they are right, this longest bull market in history is likely to go into double-overtime.

About The Author

Bryan Perry

Bryan Perry
SENIOR DIRECTOR

Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.

Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license.

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