More Disappearing Rate Hikes

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The news of the strong July jobs reports sent stocks to all-time highs and caused renewed talk of more Fed rate hikes as early as September. The trouble with that prediction is that the evidence in the fed funds futures market reflects an extremely low probability for rate hikes in the rest of 2016. A look at the December 2016 fed funds futures (ZQZ16), shows a Friday close of 99.525 - after the July jobs report.

Thirty Day Fed Funds - Daily OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

As a reminder, the fed funds futures price predicts the fed funds rate by subtracting the ZQZ16 price from 100. A Friday close of 99.525 for ZQZ16 (dark line) means a forecasted fed funds rate of 0.475% at year-end. Since the present target fed funds rate is 0.50%, it is fair to say that at present fed fund futures do not indicate any probability of a rate hike. What's more interesting is that on news of the Brexit referendum outcome, this same fed fund futures market was predicting a rate cut - as the price ran up to 99.70.

Looking one year out, the plot thickens. The December 2017 fed fund futures forecast (ZQZ17), plotted in the green line above, has been bobbing and weaving in tandem with its year-younger brother but the difference between the two lines has been getting smaller. A year ago, when ZQZ16 was trading near 99, ZQZ17 was trading near 98.40.

That means that a year ago ZQZ16 was forecasting a fed fund rate of 1% in December 2016 and a fed fund rate of 1.6% in December 2017. Now that a year has passed, it would be an understatement to say that fed funds futures traders have changed their minds. At the time of this writing, the December 2017 forecast sees maybe one quarter-point rate hike by the end of next year.

The reason why I think there won't be any rate hikes in 2016 is that employment is a lagging indicator. Overall, U.S. economic data has not been on the strong side in 2016 and there are signs that business investment is hopelessly trailing the good news on the jobs front. Also, the employment picture is a bit artificial as the Labor Force Participation rate has dropped dramatically since the last recession. There are 92.9 million people not in the labor force today; that number was closer to 80 million in the last recession.

United States Labor Force Participation Rate Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

If the Labor Force Participation rate was where it was 10 years ago (above 66%), today's unemployment rate would be over 7%. I think we may see even lower participation rates in 2016 and 2017; couple that with a sluggish investment cycle and rate hikes look highly unlikely. This is why it is not surprising that long-term interest rates have dropped substantially since the Fed's misguided December 2015 rate hike.

United States Ten Year Government Bond Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I would be surprised if we don't see a sub-1% 10-year Treasury note in 2017. How far under 1% it can go I cannot be sure. Previously, many bond traders erroneously assumed that the floor was "zero," but as holders of Japanese bonds and some European government bonds have found out, zero is not a floor.

Granted, a sub-zero 10-year government bond yield is a sign of serious deflation, which we don't have in the U.S.; but all of those institutional investors from sub-zero-yield countries are probably flocking into the U.S. Treasury market right now as they have to hold a certain level of risk-fee fixed income assets.

The total of negative-rate sovereign bonds is flirting with $12 trillion at last count. The question arises: How can those assets be considered risk-free if some of them guarantee a loss in nominal terms if they are held to maturity? The only positive outcome for a nominal 10-year yield at -0.5% happens if the inflation rate is -1% for the life of the bond. That means the "real" interest rate is actually a positive 0.5%, which is the faint attraction for those who currently invest in governmental bond markets with negative yields.

I think the U.S. stock market may make substantial further gains - perhaps for the wrong reasons, since earnings growth is stagnant - but with the 10-year Treasury falling toward 1% and the dividend yield on the S&P 500 at just under 2%, any further declines in Treasury yields will put a floor under the market.

This happened with the German stock market when the 10-year bund yield declined dramatically from 2% all the way to a hair above 0% in early 2015, while the DAX 30 stock market index kept rising.

German Stock Market Versus German Ten Year Bond Yield Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Then, as this chart shows, German bund yields surged from a hair above 0% all the way to 1%. At the time (April, 2015) the infamous Bill Gross of Janus called the German bund market "the short of a lifetime," (Bloomberg April 21, 2015, "Janus's Gross Sees German 10-Year Bunds Short of Lifetime") as bund yields surged temporarily to 1%. But as I opined then, drawing parallels from a similar statement in 2003 by the legendary Barton Biggs about the Japanese bond market (see Marketmail May 4, 2015 "The "Short of the Century" May Last a Little Longer"), that short may take longer to work out. My point now is that this "short of a lifetime" has not worked out over the last 16 months - unless he meant that sharp and short-lived surge to 1% in early 2015 - so the German bund market has not been a very good short.

As German bund prices have surged and their yields have dropped to as low as -0.19% as of last month, German stock prices are no longer surging. This is because deflation has now spread to Germany. This deflation causes weak corporate earnings and revenues. For the time being, enjoy the decline of 10-year Treasury yields to 1%, but don't forget that there is a limit to interest rate sensitivity in the stock market.

Commodities Nearing 25-Year Lows

The dramatic weakening of commodity markets in July, led by oil, is not making that many headlines as the S&P 500 Index hits another all-time high. Still, this dramatic weakening in commodity prices is highly relevant to the present global deflationary backdrop that is resulting in negative governmental bond yields in some markets. That little zig lower in the S&P GSCI Commodity Index (pictured below) surely looks destined for a retest of the low near 1900 from January of this year, which nearly matched the Asian Crisis low in 1999. The CRB Commodity Index (not pictured) has already take out the Asian Crisis low.

GSCI Commodity Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

We don't have a similar Asian Crisis at present, but commodity prices have still collapsed. I think the main culprit for the current collapse is the situation in China. The boom in commodity prices coincided with the surge in China's GDP from $1 trillion at the turn of the century to $10.9 trillion at the end of 2015. The decline in commodity price coincides with the recent deceleration of China's growth rate.

I happen to think that the Chinese credit bubble has already burst and the Chinese are accelerating lending in order to avoid a hard landing, which I don't think can be avoided. When China had a GDP of $1 trillion at the turn of the century its total debt to GDP ratio was 100%. With over $11 trillion in GDP this year, their debt to GDP ratio is now 400%, if one counts unregulated shadow banking lending. Chinese GDP growth has been rapid, but the total leverage ratio in the economy has gone up four-fold. Such leverage ratios, in my view, practically guarantee a hard landing. It is only a matter of time before this happens.

This is why I think commodity prices are headed lower and are likely to take out their January 2016 lows. In the process, I think that the oil price will take out $20 in this environment, most likely in 2017.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

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