Friday’s February Employment Report had a little something for everybody. Nonfarm Payrolls were up 242,000 (consensus called for 190,000), and the January report was revised up another 21,000. In addition, the Labor Participation Rate ticked up to 62.9% (was 62.7%). However, the more important number, in my opinion, was Average Hourly Earnings (AHE). Last month, AHE increased 0.5% month-over-month and increased 2.5% year-over-year. This was the sign the Federal Reserve (Fed) had been waiting for—wage inflation was picking up. Friday’s report showed AHE down 0.1% month-over-month and 2.2% year-over-year. Moreover, Average Weekly Hours also fell (34.6% to 34.4%), exacerbating the drop in wages. So much for wage inflation in the U.S.A.
The Fed can afford to be patient and keep the “wait and see” attitude with regard to what many Fed observers have termed “tight financial conditions” or in layman’s terms, “The rest of the world is a complete mess.”
As I was waiting for last Friday morning’s U.S. employment report, I realized that this may be the only report in the world right now that indicates a healthy, growing economy. Seemingly, every other economic report from Europe or Asia or Latin America is expected to stink, and they rarely disappoint! The United States economy stands alone in the fight against global economic recession. I have a picture of England standing alone after France fell in 1940—probably too dramatic, but it is a pretty cool picture, nonetheless.
When the various reports are released from the European Union or Japan, and they show sharp declines in growth and even bigger declines in inflationary measures, my first thought now is, “What are those crazy central bankers going to do to get out of this one?” The picture that comes to mind isn’t one of a Matt Damon- or Gerard Butler-character facing an impossible situation and somehow through sheer brilliance, figure out the solution and save the day. Rather, I think of those old Three Stooges shorts where Moe, Larry, and Curly come to fix somebody’s plumbing. If you recall, they usually turn a slow leak into a flood that pulls the house down the street! Hence, today’s title “Half-Wit Holiday,” which happened to be Curly’s last movie appearance.
Next Thursday, the European Central Bank (ECB) will meet, and there is a high expectation of additional stimulus in the form of greater negative rates and more Quantitative Easing (QE). As I wrote in last week’s article, the combination of these two policies, both in Europe and Japan, are a recipe for disaster for their member banks. Very recently, there has been talk from the ECB that it will try to implement some sort of tiering mechanism that punishes its banks less by only charging on new excess reserves or some excess reserves or some other iteration.
It’s a little scary to think about. It’s akin to surgeons arguing about how they are going to perform an operation while the patient lies bleeding on the operating room table. I believe, and this is pure speculation on my part, that the more conservative members of the ECB, most notably the Germans, will push back on tiering schemes because, to begin with, they hate negative interest rates. The idea of experimenting to make it “less painful” is probably a cop-out in their opinion. It just allows the ECB to do more of what they (the Germans and probably the Dutch) already don’t want them to do. Next Thursday should be interesting.
When you combine today’s weak U.S. February AHE data, and the high probability of more negative rate policy form the ECB next week, I feel our rates markets have room to rally, particularly after some pretty hard selling off this week.
Finally, as the belly of the Treasury curve (5-year and 7-year) has increased in yield 14-15 basis points, respectively, over the past two weeks, the S&P has rallied 4% and investment-grade corporates have tightened about 12 basis points. In the same time period, high-grade municipal bonds have widened about 10 basis points in the same belly of the curve. Municipals are trading very directional now. When we are in “risk-off” mode, municipal spreads tighten significantly as investors seek relative safety. This is why I believe we saw a fair amount of crossover buying when risk markets got ugly in January and February. Municipals were gaining at the expense of Investment Grade (IG) Corporates. Conversely, when we are in “risk-on” mode, as we have been the last two weeks, municipal spreads widen as investors feel more comfortable about risk, and focus on the IG market, buying the tremendous amount of new issuance with a vengeance. Municipals were ignored to some extent as new issuance came to market, widening the sector.
I believe that municipals are going to trade long, and what I mean by “trading long” is, when Treasuries rally in “risk-off” mode, Municipal spreads will tighten (the price of the bond gets the double benefit of the underlying Treasury rate declining, as well as the Municipal spread to Treasuries declining) and the reverse if we go “risk-on” mode and Treasury rates increase. We have seen the latter the last two weeks, and I think that runs out of steam very soon. If we reverse course, and I think we will, then there’s an opportunity to buy Municipals at relatively wide levels and take advantage of their interest rate and spread duration if Treasuries rally.
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