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HIGHER INTEREST RATES TO COME!

Last night, just as we were winding-down Fourth of July Celebrations with fireworks here in the U.S., North Korea was demonstrating their own version of “rockets red glare” by proceeding with their missile tests. European stock markets and stock futures around the globe sunk lower as geopolitical tensions increased. If you looked at the early morning financial news, it seems that most of the market movements were attributed to the North Korean missile tests. Supposedly, crude oil and gasoline are higher, gold and silver are higher, and stock markets are lower because of North Korea’s display of hostility. After digging deeper, the bigger story has more to do with the Federal Reserve and their interest rate policy. The wild movements in the currency and bond markets since last week have more to do with Fed rhetoric, inflation expectations, and employment data. The real market mover today was the ADP employment report.

On Friday the government will release the report on job creation for the month of June which now has a consensus forecast growth of 155,000 new jobs. This morning the ADP National Employment Report estimated non-farm private employment grew by 368,000 in June. The report claims to have a 90% correlation to the numbers that will be released by the Bureau of Labor Statistics on Friday. With a 90% correlation, the low end of job creation would come in at 331,000, a far cry from the consensus estimate of 155,000. This new employment data has thrown the markets a curveball since the Fed meeting last week. The fear of higher interest rates is the driving force behind the market movements for today. Strong economic data suggests the Fed is not done raising rates quite yet.

Digress to Last Week’s Trading

Two weeks ago I commented that it would be interesting to watch the Treasury auctions on June 27th and 28th, along with the meeting of the Federal Reserve on June 29th and closing of the second quarter June 30th. Indeed it was all very interesting. Tuesday and Wednesday the government borrowed money by auctioning Treasury debt, and markets acted just as I had anticipated with very low volatility for the two days, a stable dollar, and gold and silver that would get whacked one more time, or at least be held in check. The day before the auctions gold closed at $588, and on auction days it closed Tuesday at $584 and Wednesday at $581. The Treasury debt was sold and everyone was happy. With the auctions done, I see gold is now nearly $50 an ounce higher and it was helped higher by the Fed on Thursday.  

Last week the markets went into party-mode after the Federal Reserve changed the language in their statement to appear less hawkish toward inflation. Many traders took the softening of the language as an indication the Fed would stop raising rates sooner rather than later. The Dow Industrial Index took-off for its biggest one-day gain in three years and bonds rallied on the prospect the Fed would back off the rate increases. For the broad stock market it looked more like a giant short-squeeze where stock prices continued melting higher. The Fed jump-started stocks higher with softer language on inflation, the shorts began buying to cover and the momentum players piled-in on top to continue driving stock prices higher to close the quarter. Monday stocks got some weak follow-through with new money coming in on the first of the month, but today it’s back to reality.

As stocks and bonds moved sharply into rally mode on Thursday following the statement by the Fed, the corollary happened in the foreign exchange markets. Traders sold the U.S. dollar off with a vengeance! The markets were primed for strong “inflation fighting” words from the Fed, but the language was more dovish than expected. In May they said, “Some additional firming may be necessary,” but last week they moved to, “The extent and timing of any additional firming that may be needed to address risks will depend on the evolution of the outlook for inflation and economic growth.” As I watched the currency trading on Thursday and Friday all I could think to myself was that dollar holders were not happy with the Fed’s weaker stance on inflation.

Currency valuations will fluctuate with relative interest rate differentials between currencies, but overall the markets are now saying the interest rate increases so far around the globe will not be enough to fight inflation. Today crude oil took off to close above $75 a barrel and gold gained over $13 and ounce. Note that these gains in commodity and precious metals prices come on the same day the dollar strengthens. The hot employment report today rekindled all the fears that the Fed will have to continue raising rates. It will take higher interest rates all around the globe to stop this inflation monster. Overall global consumption of commodities will have to be slowed down if commodity price inflation is going to be stopped. Interest rate differentials between countries will affect currency valuations, but interest rates must move higher and the supply of money must be slowed down if global consumption and commodity price inflation is going to be contained.

Rate Pressure from Around the Globe

On Monday, Japan’s Tankan survey was released to show higher growth from the first quarter to the second. The report is a measure of large manufacturers in Japan and it stated that capital spending plans for the fiscal year are up a strong 11.6% versus 2.7% the previous quarter. In today’s headlines, Kyodo News is reporting the Bank of Japan will raise rates by 25 basis points next week following the release of the stronger than expected Tankan report from Monday. While it looks like Japan is poised to raise rates, the news from Europe today has the euro zone purchasing managers index higher to 60.7 in June versus 58.7 for May. The June reading is the highest in six years and probably suggests the ECB will also proceed with rate increases. Tomorrow we will get the announcements from both the ECB and the Bank of England on their interest rate policies.

If foreigners continue to see inflation, they will continue to raise interest rates. The Federal Reserve has moved from 1% to 5.25%, Japan is still somewhere around 1%, and the European Central Bank has moved from 2% to 2.75%. Check this excerpt from one of today’s articles from Bloomberg:

Euro Climbs as ECB's Trichet May Signal Further Rate Increases

July 5 (Bloomberg) -- The euro rose to a four-week high against the dollar and a record versus the yen on speculation the European Central Bank will signal it may speed up the pace of interest-rate increases.

An industry survey today may show expansion in service companies in the euro region quickened last month, adding to pressure for the higher rates that has helped push up the euro 8.3 percent this year. The ECB will probably keep the benchmark rate at 2.75 percent when it convenes in Frankfurt tomorrow, all but two of 46 economists surveyed by Bloomberg News said.

"The euro will remain well supported by expectations of a hawkish statement on rate policy after the ECB meeting tomorrow," said Yuji Kameoka, a currency analyst at Daiwa Institute of Research, a unit of Daiwa Securities Group Inc., Japan's second-largest brokerage.

I find it interesting to note the comments above from the currency analyst at Daiwa Institute of Research. He says the euro will be supported with no change in rates tomorrow, but will get its support from a hawkish statement on rate policy. Last week in the U.S., we actually raised rates, but the dollar was trashed with dovish language from the Federal Reserve. With the Fed at 5.25% and the ECB at 2.75%, the U.S. is forced to offer a higher yield on its bonds to give the dollar credibility. If the ECB finds it necessary to move to 5% over the coming year to fight inflation, does it follow the U.S. rate will have to be somewhere around 7.5% or higher? If that scenario plays out, we will be looking at 8.5% mortgage rates…ouch for the housing market!

While many here in the U.S. believe the Fed is somewhere near the end of its tightening cycle, it looks like Japan and Europe could be getting started in earnest to raise rates. Interest rate changes by different countries will clearly play out in relative currency valuations, but overall around the globe interest rates will need to move notably higher to stop price inflation. Excess money creation and historically low interest rates have fueled an increase in consumption of global commodities. Interest rates will have to move higher than expected to slow down economies all around the world (try China at 10% growth). Just when the Fed may want to pause on rate increases, they might not have the choice if rates go up overseas. In the end, the Fed will protect their Federal Reserve Note (a.k.a. U.S. dollar) with higher rates…they have to!

I believe what we saw in the markets today (stocks lower, dollar support, bonds lower/rates higher, precious metals/commodities higher) is what we will continue to see as the Fed stays behind the inflation curve. By saying “behind the inflation curve” I mean the Fed will continue to pretend to fight inflation, but continue inflating all along the way. If they really want to stop price inflation with higher interest rates to slow global consumption, they have a long ways to go. In the shorter term, I expect to see stock and bond prices move lower while the global boom for commodities continues. The big reaction to the Fed statement last week was both premature and overdone. Expect rates to continue moving higher and be careful in the overall stock market as growth should slow further in the second half of this year.

By the end of today’s trading the DJIA dropped 76 points to 11,151 and the NASDAQ Composite fell 37 points to 2,153. Bond prices moved lower pushing yields higher as the strong economic data suggests the Fed will continue raising rates. The dollar index moved 0.5% higher to 85.27. Energy and precious metals moved higher. Tomorrow we get jobless claims, Monster Employment Index, Challenger Job-Cut Report, BOE and ECB announcements, ISM Non-manufacturing Index, Pending Home sales, Chain Store Sales and the EIA Petroleum Inventories, but the BIG report will be the job creation data for June to be released on Friday.

Have a Great Evening!

Mike Hartman

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