In this article, I will review the recent statement made by Fed chair Janet Yellen about the possibility for rate hikes in 2017 and the latest ISM Non-Manufacturing report. The rate hike in March appears to be locked in. I am surprised with the speed at which the market changed what it was pricing in. There have been some good survey reports, but nothing dramatically new since mid-February when the market didn’t expect a rate hike. I think this was a case of the market’s initial expectations being wrong and it correcting itself. I said if the Fed wanted to make March a ‘live’ meeting, it would need to act aggressively in changing the market’s perception as the odds in mid-February were showing about a 20% chance of a rate hike. The Fed made that change which is why the market reacted the way it did. I was wrong in my prediction that no rate hike would occur. The ISM Non-Manufacturing data is one example of a great survey report which may have helped move the needle towards an accelerated rate hike schedule.
Before I delve into Yellen’s speech and the ISM report, I would like to review the recent occurrence where the VIX has been coupling with the S&P 500. Usually the VIX and the S&P 500 are the inverse of each other, but sometimes for short periods of time they act in tune. This may be because of trades which have gone rogue such as a hedge fund that is forced to liquidate its position because of poor performance.
The chart below shows the previous times the VIX and the S&P 500 have had a relatively high correlation. As you can see, the current correlation is the highest it has been in the past two years. The previous times when the VIX and the S&P 500 were relatively correlated, a correction in the S&P 500 followed soon afterwards. I have made the point that either the S&P 500 was going to fall or the VIX would fall. Unlike the previous times they were correlated, this time the VIX corrected instead of the S&P 500. Today, the VIX fell 7.20% while the S&P 500 was only up 0.05%. The VIX made up for the recent rally it had by falling back down to earth. Considering the fact that there has been 98 days without a 1% fall in the S&P 500, the VIX should be near its all-time low; it’s now at 10.96.
As I mentioned, the Non-Manufacturing ISM report was great just like the Manufacturing report. The Non-Manufacturing Index was 57.6 for February which was the best report in the past 12 months and beat expectations for 56.5. This report is consistent with 3.4% GDP growth. However, as I mentioned after the Manufacturing report, these surveys are more optimistic than reality as the Atlanta Fed is still expecting 1.8% growth in Q1. This isn’t to say the ISM reports are worthless; we are in a rare period where the ISM is out of tune with the hard data. Either the ISM will fall in the next few months or economic growth will accelerate higher.
As you can see from the chart above, most of the components of the ISM report are accelerating. Activity increased from 60.3 to 63.6 which is the best report since February 2011. New orders improved from 58.6 to 61.2 which is the best report since August 2015. It’s easy for the bears to discount this as merely soft data, but the positivity cannot be ignored. I’m not saying the economy can’t slip into a recession in the next few months, but it would be unprecedented based on this data. As you can see in the chart below, in the last cycle the Non-Manufacturing Index was at the current level near the peak of the cycle in the mid-2000s.
Janet Yellen spoke about how a rate hike in March is now nearly certain and that 3 rate hikes in 2017 seems appropriate. This caused the CME Group website to show the odds of a rate in March increase from 77.5% to 79.7%. It’s nearly certain that the Fed will raise rates. The only potential metric which can change the action would be if the employment report next Friday shows unexpected weakness. Usually, the report is on the first Friday of the month, but it was pushed back one week due to a scheduling quirk.
Janet Yellen stated if the Fed waits too long to raise rates, then there is a risk the economy overheats. This is counter to what she stated last year. Last year she said the Fed may let the economy overheat a bit. To be clear, she’s referring to inflation. Letting the economy overheat means letting inflation rise above the Fed’s 2% target. I criticized her when she said she would let the economy overheat. It’s great that she backtracked, but I will note if oil prices fall, inflation may not be as robust as it has been lately.
The banks love the news of Fed rate hikes as it means their net interest margins will expand. Goldman Sachs hit an all-time high today and JP Morgan and Wells Fargo are within a couple percentage points of their all-time highs. The chart below shows the XLF’s (financials ETF) gross value added multiple. It is at an all-time high. The deregulation and expanding margins are going to make this valuation metric look more reasonable in the future, but it does look like a bubble if those changes don’t act as exceptional profit growth catalysts.
Conclusion
The economy is operating at the same speed it has been at in the past few years. This stall speed is expected to pick up as seen in the roaring stock market and great ISM reports. The Fed is now expected to raise rates 3 times this year. The banks are loving the rate hikes as they are rallying to nosebleed levels. The same question as to how much of a boost Trump’s fiscal policies will give to the economy remains unanswered. Some bulls believe not knowing what future policy will be or how it will help the economy are good things. I think they may know that Trump’s policies can’t meet Wall Street’s optimism, but don’t want to admit it.
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