New Federal Reserve Chairman Janet Yellen delivered her first congressional testimony today in front of the House Financial Services Committee.
And financial markets liked what they heard. As of 1:30 p.m. New York time the Dow Jones Industrial Average was up 1.23% and the Standard & Poor’s 500 1.03%. Germany’s DAX Index closed up 2.03% on the day and in Asia, where markets closed well before Yellen started to talk, Japan’s Nikkei 225 Index was up 1.77%, Hong Kong’s Hang Seng was up 1.78%, and the Shanghai Composite was ahead 0.84%.
Yellen stressed continuity with former Fed chairman Ben Bernanke’s policies. The Fed would continue to reduce its purchases of Treasuries and mortgage-backed securities at a speed dependent on the economic data. The slow pace of job creation in December and January was certainly disappointing but, Yellen cautioned, two months of data weren’t enough to bring a change in the central bank’s taper policy. The Fed’s Open Market Committee doesn’t meet again until March, she noted, and that will give the bank another month of data to examine.
Most important Yellen successfully—for the moment—addressed the market’s anxiety about the falling unemployment rate. Read more
Two questions after today’s surprisingly grim December jobs report.
First, why did the U.S. economy add only 74,000 jobs in December? That’s a huge drop from the 241,000 added in November. (This figure was revised upwards from 203,000.) Economists surveyed by Briefing.com were expecting the economy to add 197,000 jobs in December.
Second, why has the U.S. stock market shaken off this big disappointment? The Standard & Poor’s 500 stock index was actually up 0.23% at the close. Emerging market stocks were up even more with the IShares MSCI Emerging Markets index ahead 1.8%. Emerging markets that trade roughly on New York time were up too—Brazil was ahead 0.8% for the day and Mexico 2.1%–so this isn’t just an artifact of markets closing before they heard the bad news.
Explaining this jobs report is basically guesswork at this point. Maybe the U.S. economy isn’t as strong as all the other data have indicated recently. Maybe this disappointing number is a result of statistical error in the always-problematic seasonal adjustments for holiday hiring, especially in a year when Thanksgiving fell so late in November. Maybe the frigid weather in December reduced hiring. Maybe November pulled jobs from December.
At this point we don’t know whether this very disappointing result is a significant data point that should lower projections of the economic trend or a one-off event that doesn’t say much of anything.
Wall Street is certainly more than willing to entertain the possibility today that this number is just a one-off event caused by weather or faulty seasonal adjustments.
But that’s not the only reason for the surprisingly positive response (or in the U.S. markets, the surprising absence of a more pronounced downward move.) Read more
What looks likely to drive the financial markets once Santa is back at the North Pole and his rally has passed into the record books?
Here’s what I think deserves watching as we turn the corner into January.
- Yields on the 10-year Treasury are pushing 3%. In fact yields pushed briefly to 3.01% today—the highest level since July 2011. Nothing magical about 3% versus, say, 2.96% but 3% clearly has the market’s attention and this level is a benchmark that investors and traders are watching to gage the reaction to the December 18 Federal Reserve decision to begin tapering its $85 billion in monthly purchases of Treasuries and mortgage-backed securities. 3% isn’t enough to stall a rally, but it is likely to make the cautious more cautious.
- The Japanese yen closed at 105.14 to the dollar today and it looks like the next test will come when the currency falls to 107 to the dollar. Read more
After rallying in September and October in anticipation of rising inflation in 2014, TIPS (Treasury Inflation Protected Securities) have dropped like a stone in the last month. They’re now down 8.8% in 2013, the biggest drop, according to Bank of America Merrill Lynch, since they were introduced in 1997.
According to the TIPS market forget about inflation in 2014. It’s a slowdown in price increases—which isn’t the same thing as deflation by a long shot—that faces the financial markets and the economy next year.
The gap in yields between fixed-rate Treasuries—where the payout doesn’t change with inflation—and TIPS—where the bond pays out more as inflation rises—shows the market predicting that inflation, by official measures, will average 1.75% over the next five years. That’s a huge decline from the year’s high in March when the TIPS market was pricing in a 2.42% inflation rate. (Economists surveyed in Bloomberg are expecting consumer price inflation of 1.5% this year. That would be the lowest rate since 2009 and the second-lowest annual rate since 1963.)
This view on inflation is a huge turnaround from the earlier consensus that the massive expansion of the Federal Reserve balance sheet would result in an increase of inflation as the increase in the money supply fed into the economy. The Fed’s balance sheet has climbed to almost $4 trillion from $900 billion in 2008 as the U.S. central bank bought financial assets to lower interest rates and stimulate the economy. (Similar increases in balance sheets and money supply by the European Central Bank and the Bank of Japan would result in global inflation, the consensus held.)
By it now looks like a decline in wages and employment and the associated weakness in demand will trump central bank printing presses. At least for a whie.
Now the TIPS market doesn’t have to be right. Read more
There’s increasing reason to believe that the Treasury market has stabilized on the fundamentals—until the next panic when the Federal Reserve again begins to talk as if a decision to taper off its program of buying $85 billion a month in Treasuries and mortgage-backed assets is just around the corner.
And if the Treasury market has stabilized, it means that the weakness in dividend stocks (calling it a sell off would be an overstatement) is at an end—for a while—too.
The latest piece of evidence comes from a Wall Street formula called the term premium, which measures the risk of holding long-term bonds by factoring in the market’s outlooks on inflation and economic growth.
If you assume that consumer inflation will continue for the rest of 2013 at something like the current low rate–the lowest rate since 2009; and if you assume that U.S. economic growth will stumble ahead for the rest of 2013 by something like 2% or so rather than “racing” ahead at 3%, then the current 10-year Treasury yield of 2.54% is about right.
The long-term reading on the term premium has been an average reading of 0.40% in the decade before the financial crisis in 2007. It’s now at 0.46%, according to Bloomberg. As recently as May 2013 the term premium was a negative 0.5%. The term premium has been in negative territory since October 2011 and turned positive only in June 2013.
What does all that mean? The term premium is the extra yield that investors require before they will buy a long-term bond instead of a series of short-term bonds. If, for example, the yield on a 10-year Treasury were 5.5% and holding a series of 1-year Treasury bills over the next 10 years would be expected to yield 5%, then the term premium would be 0.5 percentage points or 50 basis points.
In most periods you’d expect the term premium to be positive since investors would, normally, require extra yield to induce them to hold a longer-term bond. But under some circumstances the term premium would be negative. If, for example, investors wanted to lock in a long term yield instead of taking on the risk of rolling over shorter term bills—with the chance that interest rates might be lower on each subsequent roll over—then the term premium could well be negative. That is indeed why the term premium was negative in early 2013—bond buyers actually preferred locking up their money for the long term instead of taking the risk that short-term interest rates might fall for subsequent rollovers. It wasn’t necessarily that yields on 10-year Treasuries were so attractive in comparison to short-term yields. It’s just that they were preferable given the assumed unpredictability in short-term yields. Predictability is a valuable commodity for pension funds and insurance companies that want to match the timing of their cash outflows and the timing of their cash inflows.
The big reason that bond buyers have started to see 10-year Treasury bonds as fundamentally attractive again—aside from their big recent drop in price and rise in yields—is the absence of any signs of inflation. Look around the globe—can’t find it. Can’t even find a scenario that might produce it relatively soon. At current economic growth rates, the global economy is awash in capacity whether it’s capacity for manufactured goods or production capacity for commodities. With China’s economy slowing that global overcapacity doesn’t look likely to go away quickly. (The one exception to this pattern of modest inflation is, perhaps, food commodities but even there the potential for a record harvest this year has pushed down near-term prices.)
Real yield on the 10-year Treasury—that is the yield once you subtract current inflation—is 1.56 percentage points, the highest level since March 2011. As recently as November, real yields were negative.
This hasn’t been a great first half for Treasuries and other bonds. Treasuries, according to the Bank of America Merrill Lynch bond index, lost 2.48% in the first half of 2013, the biggest loss since 2009
But Wall Street now believes that bond prices have stabilized within a likely range for the 10-year Treasury of 2.4% to 2.8% for the rest of 2013. High levels of bond market volatility and the uncertainty over when the Fed might begin The Taper argue that bonds yields aren’t going back to former lows, however.
What does this mean to you? Read more