It may seem like politics and the possible policy changes that will happen when Donald Trump wins the election are the only things that are moving the markets right now. Get ready to face the truth.
Data from the job market this week, including the very important November jobs report that is coming on Friday, will have a big effect on the Federal Reserve’s plans to lower interest rates. That will then be very important to people who buy in stocks, trade bonds, and do anything else that has to do with the financial markets.
Brent Schutte, chief investment officer at Northwestern Mutual Wealth Management Co., said, “I think the market would like to see something positive, but not too positive” in Friday’s jobs report.
Schutte said, “If it’s incredibly positive, then that makes me wonder if the Fed will actually cut rates.”
That could be a problem for a stock market whose prices are already high compared to the past. People are hopeful that the rally will last until 2025 because they think that the Fed will cut interest rates, which will lower market interest rates and make those valuations more attractive. It’s harder to defend high prices when interest rates are high, since they lower the present value of future cash flows and earnings.
Some buyers may understand Schutte’s point about valuations and the Fed if they know or have lived through recent stock market history.
As Nicholas Colas, co-founder of DataTrek Research, observed in a note last week: “Readers of a certain vintage will recall that the 1990s dot-com bubble ended when, in Q1 2000, the Fed made it clear that they would raise short-term rates above their mid-1990s highs” just above 6%.
He said that the boom burst because investors and the prices of stocks were not ready for the Federal Reserve’s message or the rate hikes that brought the fed funds rate to 6.5% by the middle of 2000.
“Yes, the rate hikes were small, but they made it clear that the FOMC wanted to slow down the U.S. economy.” “This was enough to dramatically cool the market’s animal spirits,” he wrote, adding that DataTrek still sees a bright future for stocks and doesn’t think the same thing will happen again soon.
According to the CME FedWatch Tool, traders in Fed-funds futures have priced in a 66% chance that lawmakers will lower interest rates by 25 basis points, which is a quarter of a percentage point, next month. This would be the third cut this month, after a half-point cut in September and a quarter-point cut earlier this month. The Federal Reserve’s favourite measure of inflation, the October personal-consumption expenditures index, went up a little but still met economists’ expectations on Wednesday. This made those expectations a little stronger.
Fears of the job market getting even worse were used as an excuse by the Federal Reserve to start its monetary easing cycle with a big rate cut in September. In his statement at an annual symposium in Jackson Hole last summer, Federal Reserve Chair Jerome Powell warned that the job market could not get any worse.
Some investors are hoping that the Fed will take a break when they meet next month because the economy has been strong and inflation has been staying high since they started cutting rates.
For the Fed’s part, minutes from the November meeting released last week showed uncertainty over where exactly the neutral rate lies — the level at which the Fed’s policy rate neither boosts nor slows the economy — and led participants to argue for a more “gradual” pace of cuts.
The Fed’s problem is that the current inflation data and the Taylor Rule, which is a way for economists to figure out where interest rates should be based on inflation and economic growth, show that the fed-funds rate should stay the same. This was written by Steve Blitz, chief U.S. economist at TS Lombard, last week.
“While I believe they are still biased to cut, the November payroll data end up being critical for this data-dependent FOMC,” he wrote, referring to the Fed’s rate-setting Federal Open Market Committee.
At the same time, stocks are starting December with a lot of energy. The S&P 500 SPX 0.56% rose 1.1% in a week shortened by the Thanksgiving Day holiday Thursday and an abbreviated Friday session, logging its 53rd record close to gain 26.5% on the year. The Dow Jones Industrial Average DJIA 0.42%briefly topped the 45,000 milestone and ended at a record, while the Nasdaq Composite COMP0.83%
logged a monthly gain of over 6%.
Treasury yields offered some relief for any worried equity investors this past, holiday-shortened week, with the 10-year Treasury yield
TMUBMUSD10Y 4.210% retreating nearly 22 basis points to 4.192%, its lowest since Oct. 21. It had jumped to more than 4.5% earlier this month, part of a rise that had taken the yield from around 3.6% in late September.
With bulls feeling the glow of post-election euphoria and upbeat seasonal factors, the near-term risk may be that investors themselves are feeling too good about the market’s prospects.
Last week’s November consumer-confidence index survey showed expectations for stock prices to be higher in 12 months at an all-time high, noted economist Ed Yardeni of Yardeni Research, in a note.
“If there’s one thing Americans seem to agree on, it is that stocks are going up…From a contrarian perspective, this suggests that a pullback is likely,” he said (see chart above).
Getting back to the fundamentals, the economic data and the post-election rally aren’t as disconnected as may appear.
“Markets care about real political change, not so much politics,” said Lauren Goodwin, economist and chief market strategist at New York Life Investments, in an interview. “Another way of putting it is that that the trades we think are more durable are those that are backed up by broader economic themes.”
Trump’s victory has investors penciling in stronger economic growth, partly due to expectations for tax cuts and deregulation, lifting stocks. It has also sparked fears of resurgent inflation, lifting bond yields. But it’s important to note that those market moves are also what an investor would expect given resilient economic data and inflation data that’s been coming in a bit hotter than expected.
