By Paul Nolte.
“Full of sound and fury, signifying nothing.” While that is usually the only part of the quote that is used, the words
immediately in front are: “A tale told by an idiot”. The tale told last week was woven by the fools on the hill. From the
Congressional testimony by Fed Chief Yellen, to the passing of temporary funding for Homeland Security, to the veto of
the Keystone XL pipeline and the passing of net neutrality rules, it was a busy week in Washington.
While the legislative docket gets a pass here, the grilling of Yellen got a bit spirited as House members jousted with her regarding the Fed activities and hoping to impose additional rules. For her part, Yellen indicated that “at some point” the Fed will have to consider increasing rates, which means they could raise rates as soon as June or by yearend.
The better on Wall Street is still for a hike in June and little in her testimony indicated that is off the table. The next worry for investors is how rapidly the follow-on increases come and the impact of the hikes on the economy. The economy, according to the most recently revised GDP figures, showed growth barely above 2%. This week will have updates on manufacturing growth and the always highly anticipated employment figures. Rather than the unemployment level, we’ll be focused upon wage growth to see if last month’s jump can be sustained.
The strong rally in February more than reversed January’s decline and is reminiscent of the action from last year. As we
have highlighted before, in 2014, the bottom for the year was put in at the end of January. This year has followed that
pattern, just with a more aggressive February move. So what about March? If this year follows last, it will be rather
uninspiring with minimal gains. However once the weather warmed up, the fireworks started!
The extremely low volatility during the steady February rise has given way to complacent investors. When looking at various indicators of investor bullishness, many readings are at or near extreme levels. The characteristics of sentiment of late have been a sharp decline to scare investors to be followed by another rally to all-time highs. So March could be marked by an uninteresting market from beginning to end but a very volatile middle that shakes up investor confidence. Investors are certain rates will stay very low for very long, even as the Fed indicates otherwise. They are also certain that in a low rate environment the only investment to make is in stocks. As a result, valuations continue to get stretched. At some point it will snap back.
For the only the fourth week since the end of 2013 has the bond model flipped negative. Given the extremely low rate environment and the lower bound of zero for rates, at some point the model was going to move to a negative reading with just a minor move in rates. For an “official” change in the rate outlook, the model needs to be negative for more than two consecutive weeks, which was last achieved during the third quarter of 2013. Interestingly, since the model’s inception in 1989, the average length of a negative reading is merely six weeks. If we are to enter a long-term rising rate environment, many characteristics of the model will likely change and our investment stance will likewise change.
There is a disconnect between the price of energy on the futures market and at the pump. While the energy markets
remain near their lows, pump prices have increased 10-15%. Welcome to the annual changeover to “summer” blends.
Historically the spring is when pump prices normally rise as refiners are switching over and capacity is strained. Prices
should rise another 10% or so before peaking around April before resuming at least a modest decline. Everyone has been
focused on rig counts and pointing to the huge decline as a sign of terrible things to come.
Six period times rig counts dropped 25% or more in a year, but the economic and even energy price implication is spotty. The last two rig drops did coincide with a recession, however the four earlier periods saw either no recession or a lead time of over a year. Three of the periods followed price spikes and by the time rig counts were off 25%, energy prices were already on their way to stabilizing. Given the lack of consistency in the historical record, it is hard to make a generalization about the future of either the economy or oil prices based upon annual change in rig counts.
The markets are likely to take a breather for much of March while digesting the gains of February. We are noticing some
weakness in interest rate sensitive stocks (like utilities), but status quo for much of the rest of the market. Interest rates
may be in a broad trading range until we see signs of higher inflation. The economy is ok, but likely does not warrant
much higher rates between now and yearend.
