The Fed Gets The Green Light

|
Includes: DIA, EWU, GLD, SDY, SPY, TLT, UUP, XLP, XLU
by: Eric Parnell, CFA

Summary

The August employment report was revealed on Friday morning to much fanfare.

As anticipated, the latest monthly jobs reading came in short of expectations.

But the number was still solid enough to support a quarter point interest rate increase by the U.S. Federal Reserve at their upcoming policy meeting on September 20-21.

The August employment report was revealed on Friday morning to much fanfare. As anticipated, the latest monthly jobs reading came in short of expectations. But the number was still solid enough to support a quarter point interest rate increase by the U.S. Federal Reserve at their upcoming policy meeting on September 20-21.

A Measured Miss

Indeed, the employment reading for August came in short of Wall Street expectations. While this is notable, in reality it would have been more of a surprise had the number met or beat expectations. After all, this latest miss marked the six consecutive August and tenth out of the last 11 August employment reports dating back to 2006 where the preliminary reading on monthly jobs came in short of expectations.

What!?! Such a relentless track record of missing expectations over so many years by Wall Street analysts? We need to get some of these economics folks over to the equity research side where they seem to have the opposite problem that somehow cannot be fixed where corporate earnings keep beating their expectations time and time again. But I digress.

So the number missed in keeping with the historical pattern. But how bad was the miss? At 151,000 new jobs for August, it missed the 180,000 estimate by -29,000. A decent miss, but when compared to the misses of the past five years, it falls on the better side of the spectrum.

Moreover, if 2016 turns out like all other past Augusts in recent memory with the exception of last year, there is still a very good chance that the number could end up getting revised higher in the next two months to ultimately beat expectations once the final number comes in.

From a longer-term perspective, the three month moving average on jobs continues to trend strongly in the right direction. After bottoming at +118,000 new jobs in May after a slower March and April jobs number followed by the particularly poor May reading, the three month moving average has since trended sharply higher to +232,000, which is +42,000 higher than last month. This is thanks to good readings in June and July that have collectively held up during subsequent revisions that included +20,000 new jobs being added to the most recently reported month in July.

So while the preliminary number for August may have missed expectations it was measured at best and certainly not enough to set off any alarm bells that might scare off the Fed from a rate hike.

But Doesn't The Fed Need More?

But doesn't the Fed need to see more economic improvement than this to justify raising interest rates later this month? Not necessarily. After all, Fed officials including Chair Yellen and Vice Chair Fischer have been fairly vocal since their last FOMC meeting in late July that if the employment numbers came in solidly enough it would support an interest rate increase as soon as September.

Remember that it was Fed Chair Yellen herself that stated just last week that the case for raising rates would remain supported as long as subsequent economic releases "continued to confirm" the strengthening we have seen in recent months. In short, economic conditions did not necessarily need to get markedly better to support the idea of a rate hike as soon as September. Instead, they just need to be good enough to keep current trends moving in the right direction, and the preliminary number for August succeeded in this regard. It wasn't a great number, but it was still more than good enough.

But Does The Economic Data Really Justify A Rate Hike?

But isn't the U.S. economy still too weak and inflation too soft to support raising interest rates? This is absolutely true despite what the stock market might be signaling otherwise. Yes, the current economy and its rate of economic growth does not justify an interest rate increase today. But it also has not justified keeping "emergency" monetary policy measures in place anymore either. Taking this one step further, it also didn't justify at the time adding another $2 trillion in "emergency" stimulus to the Fed's balance sheet from 2010 to 2014 either. In other words, the Fed is not thinking about raising interest rates today because the economy is strong. Instead, the Fed is looking to raise interest rates as long as the economy is strong enough so that they can gather at least some ammunition for the next time the economy starts to fall back into recession at some point in the future. After all, we are currently in the seventh year of an economic expansion that historically less than four years on average with many readings signaling that we may already be starting to slide past peak levels. While everyone is still looking at the past recession, the Fed is hopefully being wise to look toward the next one in their thinking about potentially raising rates.

But What About The Election?

Many have cited the fact that the Fed will be reluctant to hike rates in September due to the potential that the subsequent market reaction might influence the outcome of the November presidential election.

Maybe this is true, but I seriously doubt it. If the Fed increases interest rates by 25 basis points in September, the economy and markets still have seven weeks after the fact to process the rate increase and get it out of its system.

But let's even suppose we saw a repeat performance from the last rate hike in December 2015 when the stock market proceeded to fall into a seven-week tailspin.

It should be noted before even considering this possibility that the People's Bank of China (PBOC) was finishing the process of sharply contracting its balance sheet by roughly $600 billion over the course of a few months at around the same time last December that the Fed increased interest rates, which may have had something to do with the market sell-off at the time (remember the so called "taper tantrum" from May-June 2013 - was it Bernanke mentioning he might raise interest rates or the fact that China was going through a massive liquidity squeeze at the time?). At present, the PBOC is keeping its balance sheet flat along with the Fed, while the European Central Bank continues to pump away while the Bank of Japan may be set to announce another balance sheet busting stimulus program just hours before Chair Yellen steps to the podium on September 21. Putting all of this more simply, global central bank liquidity forces are likely to be more stable and supportive in the coming weeks than they were last December, thus lowering the probability for some massive equity market sell off in the wake of any Fed rate hike.

Regardless, let's still consider the possibility that the stock market goes reeling in the wake of a Fed rate hike. Is the general voting public really going to care all that much? Will the constituency that is currently expected to vote for Secretary Clinton likely to change their vote because the Dow Jones Industrial Average (NYSEARCA:DIA) drops by 2,000 points from its current all-time highs to retest the lows from earlier this year? Isn't the endlessly rising stock market and the widening income and wealth inequality gap that is associated with it part of the vitriol that is motivating the Trump and Sanders supporters and has left the Clinton team trying to explain to a certain degree even though it hasn't been her administration in power anyway? Lastly, is anyone really still looking at the stock market (NYSEARCA:SPY) as a relevant read on how the U.S. economy is doing given how disconnected it has been from economic reality for the last seven years now? The likely answers to all of these questions are no, no, yes and "wow I really hope not by now," respectively. As long as people are not getting laid off en masse between now and November, most people in the general public will likely shrug their shoulders if not secretly cheer a little if the stock market falls out of bed a bit in the coming weeks.

But even with all of this in mind, it is likely the markets will have the moxie given the current backdrop to handle a 25 basis point hike in the coming weeks. If they could rally through "Brexit" (NYSEARCA:EWU) as strongly as they did a few months ago when things looked a bit more tenuous and valuations were just as stretched (check out at the latest UK Manufacturing PMI reading for August - wow! Maybe other countries should think about electing to leave the European Union, right?), U.S. stocks should certainly be able to handle a quarter point rate rise today.

Then There's The Opportunity Cost

Overall, the Fed has an open window to raise rates at their next policy meeting on September 20-21. Many of their stated pre-conditions have now been met if not exceeded. And if they opt to try and play things safe by taking a wait-and-see approach on raising interest rates until after the election in December, the probability is meaningfully high enough that they will end up seeing their chance at getting another 25 basis points slip through their fingers.

Missing out on a 25 basis point rate increase today would also have consequences for the future. Revisiting the point made above, the U.S. economy will inevitably fall back toward recession again at some point in the future, and if the Fed is not busy collecting as many quarter point rate hikes as possible while the opportunity presents itself today, they will render themselves all the more ineffective the next time they truly need to assume a more accommodative policy stance.

Who knows? By taking the 25 basis points today, they also leave open the possibility that they could snatch another 25 basis point rate hike in December if conditions continue to hold up. They might even be able to hit their recent dot plot projections with this type of outcome and regain some credibility in the process too.

Just Because They Should Does Not Mean They Will

It is at this point that I will provide the all important caveat. Just because the Fed should raise interest rates at their next policy meeting on September 20-21 does not mean that they will actually follow through at the end of the day (although the fact that the U.S. dollar (NYSEARCA:UUP) is solidly higher today after initially selling off is notable). Not only might events arise over the next 19 calendar days that cause the Fed to stand down, they may simply just decide that its better to pass this month and wait until December (they absolutely will not raise in November barring the extraordinary). If they opt to pass on September now that all of the key data is in, however, they will cause even greater damage to their already badly tarnished credibility with capital markets. The Fed likely knows this fact, so their language is worth watching carefully over the next two weeks to see how much they try to jawbone the markets in one direction or another.

Market Implications As Of Today

Suppose the Fed opts to raise interest rates in September at the end of the day. From the perspective of today, this has potentially meaningful short-term market implications. This is due to the fact that the market according to CME Fed Funds futures remains of the view that the Fed is not going to raise interest rates in September, assigning anywhere between a 21% to 27% chance for such an outcome.

The issue associated with these probabilities is the following. At present, the market is currently heavily favored toward the Fed not raising interest rates in September. Thus, if the Fed ends up not moving as expected and all else is held equal between now and then, the subsequent market reaction on September 21 and the days that follow is likely to be fairly muted. On the other hand, if the Fed ends up deciding to move toward raising rates in the coming weeks, many market participants are likely to be caught offside by such a move. As a result, short-term downside pressure on stocks in general and more defensive dividend paying stocks in particular (NYSEARCA:SDY) as well as Treasuries (NYSEARCA:TLT) and gold (NYSEARCA:GLD) should be anticipated under such a scenario. But any such short-term correction is likely to bring with it longer term buying opportunities, particularly among those names that are likely to continue to benefit from a sluggish to weakening economic environment such as utilities (NYSEARCA:XLU) and consumer staples (NYSEARCA:XLP).

The Bottom Line

All of the key data is now in. The Fed has the green light to raise rates on September 20-21. Will they follow through? Only time will tell over the next two weeks, but they should take it while the taking is still good.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long TLT,PHYS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long selected individual stocks with a focus on defensive and interest rate sensitive names. I also hold a meaningful allocation to cash at the present time.