At least until yesterday’s abysmal jobs report, there was – just like last December – a renewed sense of optimism that just because the Fed had gotten surprisingly hawkish in recent weeks (just like it did in November) starting with the FOMC minutes, passing through the speeches of numerous Fed presidents, and culminating with last Friday’s Janet Yellen appearance, that the US economy was once again set for a major rebound, leading to a substantial repricing higher in rate hike odds which was also coupled with a boost in risk sentiment. “Maybe the Fed will be right this time” the market thought.
Alas, the Fed was wrong as yesterday’s jobs print showed all too well. As Gundlach told Reuters two days ago, “it’s like people think that the Fed has this super-secret information about how strong the economy is about to become or that the economy is about to become smoking hot.” He said that just hours before the BLS reported the worst non-farm payrolls data in nearly 6 years.
Gundlach also followed up with a comment on the Friday’s jobs report: “It is a terrible employment report and the unemployment rate fell because people gave up. People are dropping out. There is no way to sugarcoat this report. You really can’t sugarcoat it, can you? When you start to see the figures fall in temporary workers, that means people are not needed. The temp figures are the canary in a coal mine.”He added that “this puts incredible significance for next month’s employment report after May’s terrible report. It might be three strikes.“
He was referring to the Fed’s credibility, which once again took a big hit in the past 24 hours, because as we showed yesterday, rate hike odds of both a June and July hike have tumbled. The chart below, courtesy of Bloomberg, is a direct representation of not only June rate hike odds which crashed to virtually zero, but also of the Fed’s residual credibility.
On the other hand, the market should be delighted, because just like in late 2015 when the media narrative was one of constant hammering how a rate hike is good for stocks (only to do a dramatic U-turn… just like now), the reality is that the US economy is already on the verge of a recession: to be sure manufacturing already is contracting, the latest non-manufacturing ISM and Markit PMI surveys were both dreadful confirming the manufacturing malaise is spreading, wile corporate profits have not been negative for 4 quarters in a row (and according to Factset Q2 is set to report a -5% drop in Y/Y EPS once more).
As such the right question to ask is not what happens to stocks when the Fed starts hiking rates, but what happens to stocks when the Fed is hiking rates during an earnings recession. And, as BofA calculated recently, “Hiking during a profits recession usually hasn’t ended well.” The details: “The Fed has only embarked on a tightening cycle during a profits recession three other times, which typically spelled downside for the S&P 500. .. The Fed began tightening despite a recession in corporate profits, a rare occurrence. In fact, since 1971, the Fed has begun tightening during a bona fide profits recession only three other times – 1976, 1983, and 1986; two out of those three instances saw stocks drop over the next twelve months. The S&P is essentially flat from when the Fed initially hiked.”
In short: if corporate earnings are already contracting, typcially an early indication of economic slowdown, nothing good comes out of a rate hike as shown in the table below.
But wait, there’s more, because if the Fed thinks that “one and pause” will help the S&P500, it may want to check the evidence. As BofA adds, “a pause doesn’t portend good things: our Global Investment Strategy team recently noted that equity returns have been generally negative in tightening cycles in which the Fed paused for one to two quarters between the initial and second rate hike.” More: “in cycles where the Fed has paused one to two quarters between the first and second hike, equities have been in the red over the next three and six months, and were up just 3% in the twelve months following the initial hike.“
In other words, having missed its rate hike window for this summer, absent a June jobs report that somehow surges to 250,000 or more, the Fed is now stuck until September at the earliest, at which point it will go into hibernation again until after the presidential election, at which point everything wil be in flux.
This also means that now that the Fed can admit defeat because the US economy just hit a brick wall as per the BLS, Yellen’s next move to be priced in by the market may not be a rate hike at all, but a cut. Yes, a 25 bps buffer is hardly enough, but it may have to do. While for now the US economy does not support a recession-type response by the Fed, S&P 500 profits are i already in a recession, and it is they that make a rate hike here impossible.
Ironically, now that the US economy is finally cooperating with a dovish relent, all that Yellen will need is some very bad news or FX volatility out of China to help complete the cycle.
Time for another “Shanghai Accord” maybe, this time everything that was agreed upon in February but in reverse…
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