All Things in Moderation

The global stock market sell-off continues this morning, with S&P futures down 64 handles. Bonds and MBS are up small.

Markets sold off hard overnight, with Japan down 4.6%, China down 8.5%, and Europe generally down 4.5%. Commodities are getting clocked, with oil down to $39 a barrel. Emerging markets are getting crushed.

The Chicago Fed National Activity Index rebounded from -0.07 in June to 0.34 in July.

The sell-off in risky assets over the past week has pushed out the market’s forecast for the first rate hike out of the Fed. Futures are pricing in a first hike in the Dec – March timeframe. Over the weekend, Larry Summers penned an editorial in the Financial Times encouraging the Fed to stand pat for a while. He makes the point that the sell-off in assets has a tightening effect all by itself, and hiking rates in this disinflationary environment risks another 1937.

After stocks bottomed in 1932, the Dow Jones Industrial Average went on a tear, increasing almost fivefold in 5 years. In 1937, however they started a brutal 1 year bear market, where stocks got cut in half. The most common explanation for the sell-off was the Fed’s tightening in late 1936 and early 1937. Now, there are a lot of reasons for the sell-off in the 1930s (markets sensing something afoot in Europe, FDR’s undistributed profits tax, etc), but the Fed is very cognizant of their role in the “recession in the depression” and this will certainly guide their decision-making.

With stocks hitting air pockets on the downside, you would expect to see Treasuries flying. Yes, they are up, but not by as much as you would expect. Supposedly there has been massive supply of Treasuries coming out of the Middle East, which is keeping a lid on prices.

Stocks are lower this morning after Asian markets got roughed up overnight. Bonds and MBS are up.

Initial Jobless Claims came in at 277k, a bit higher than expected but still at or close to 4 decade lows. The Bloomberg Consumer Comfort Index rose to 41.1.

Existing Home Sales rose to 5.59 million in July from 5,48 million. The median home price rose 5.6% YOY to $234,000. This puts the median house price to median income ratio around 4.3x, which is higher than historical averages. Distressed sales fell 2 percentage points YOY to 7%. First time homebuyers fell slightly to 28% from 29% a year ago. Investor purchases fell from 16% to 13% and days on market fell from 48 to 42. Unsold inventory is about 4.9 months’ worth, which indicates a tight market.

In other economic news, the Index of Leading Economic Indicators unexpectedly fell, while the Philthy Fed Index rose.

With the 10 year bond trading around 2.1%, we are at 3 – 4 month lows. Loan officers, you might want to ping any of your borrowers that are floating or who were on the fence for a refi.

The FOMC minutes didn’t really add any certainty to the September vs. December debate, however it did change the market’s perception of the probability of a rate hike from 50% to 36%. The key statement: “Most judged that the conditions for policy firming had not yet been achieved, but they noted that conditions were approaching that point.” The minutes address the labor market this way: (I bolded the interesting parts for emphasis)

“Participants agreed that labor market conditions had improved further, citing increases in payroll employment and job openings, the decrease in the unemployment rate, and some further reduction in broader measures of labor market underutilization. Although the labor force participation rate declined in June and the national hiring and quits rates were little changed in May, several participants noted that reports from business contacts in their Districts pointed to continued job gains and relatively strong labor markets. They cited anecdotal reports of firms having concerns about retaining workers and facing difficulties in filling even medium- and lower-skilled jobs. However, several participants contended that, despite the progress over the past few years, some noticeable margins of slack remained, citing as evidence the high number of workers not actively searching for jobs but available and interested in work as well as the high share of employees working part time for economic reasons compared with pre-recession levels.

The ongoing rise in labor demand still appeared not to have led to a broad-based firming of wage increases. While business contacts in a number of Districts continued to report that the pace of wage increases had picked up, recent national readings on hourly compensation and average hourly earnings of employees had remained subdued. The most recent employment cost index, released in April, had suggested an increase in wage gains. However, questions were raised about how to interpret this reading because the pickup was concentrated in the Northeast and might have resulted from particular factors that were not associated solely with a general tightening of labor market conditions, such as minimum wage adjustments and market conditions in certain occupations. In addition, it was noted that considerable uncertainty remained about when wages might begin to accelerate and whether that development might translate into increased price inflation.”

I found it interesting that filling lower-skilled jobs is difficult. If that is the case, then wages at the low end of the scale are going up, whether or not the government passes a new minimum wage law. (Of course the left is going to try and claim the minimum wage law did it, if wages do in fact rise). This would push the Fed to start hiking sooner rather than later. On the other hand, conditions in China and the fall in commodities (which they also mentioned) are going to naturally pull us towards a disinflationary scenario. The Fed does not foresee any sort of contagion from China, however they thought the same thing about the end of the subprime bubble. Punch line – not many people changed their forecasts after the minutes, and it is going to probably hinge on the August jobs report in a few weeks.

Zerohedge had an interesting oberservation: The Fed last hiked rates 110 months ago. Since then there have been 697 rate cuts around the world.

Did the Bernank get himself a new boat?

Stocks are lower in the US on overseas weakness. Bonds and MBS are up

Mortgage Applications rose 0.1% last week as purchases fell 3.5% and refis rose 3.1%.

Job openings fell in June, according to the JOLTS job openings report. The quits rate was steady at 1.9% and hires was steady as well. The quits rate is an important labor market indicator to the Fed.

Chinese weakness has been driving the sell-off in stocks and the rally in bonds. Does it have staying power? Can it affect the Fed’s thinking with interest rates? IMO, the answers are yes and no. The Chinese real estate bubble is deflating – the only question is whether it will be a disorderly mess or whether the government can let the air out slowly. Given the amount of state control over the economy they may be able to engineer a soft landing, but no one else has been able to do it  – Japan came close, however they took their debt to GDP ratio to 2.2x and have had to endure 25 years of no growth (and counting) to do it.

The punch line however is that China’s economy will slow, and that will depress commodity prices and increase deflationary pressure worldwide. This probably is Treasury bullish at the margin, but it isn’t going to be the driver of Treasury prices – the US recovery and the Fed are. If anything, turmoil in China is going to be a secondary effect. I still think the Fed hikes rates 25 basis points in September and then waits to see what happens. If the economy accelerates, maybe they hike another 25 in December. If the economy flatlines, maybe they wait. Note the Fed has historically been reticent to make big changes in an election year, for fear of being accused of being political.

Everyone knows that Dodd-Frank’s limits on market-making has affected liquidity in asset markets. Stocks are already susceptible to air pockets as tight spreads and low commissions have made the market-making business unprofitable. However we are seeing it in other markets as well – gold, currencies, etc.. Citi makes an interesting observation: performance-chasing by professional investors is also exaggerating market moves. They call this a “fundamental change” in the markets. I wonder how much of it is due to ZIRP. If professional investors cannot make a return in buy and hold strategies because interest rates are too low, they have to chase performance. I suspect as rates go up, this dynamic will reverse as professional investors return to classic buy and hold strategies that work. That said, the market-making aspect is a new normal that we need to get used to.

For all the sturm and drang about volatility, the VIX (a measure of fear in the market) is remarkably sanguine at 16.

Hillary Clinton gave her server and a thumb drive to the FBI last night under subpoena. Supposedly the IG found top secret messages on her server, so this could (or at least should) potentially be serious, if Obama decides to make it serious. Supposedly the admin was the one who initially leaked the story to the press, so they may treat it seriously. As a former Naval Officer who handled classified material, I know if I had taken home top secret material, I would have been thrown in jail. Also, regardless of what the Obama Administration decides to do, someone has everything that is on that server. If it is someone’s interest to not have Hillary as president, it will get leaked to the press.