- Traders bet on faster Fed rate hikes after strong jobs report
- Yields soar but the dollar cannot capitalize – the euro is sinking?
- Equity markets take another hit as valuation rotation continues
Hot labor market
The US job market is approaching full employment at an impressive rate. Even though the non-farm payroll fell short of expectations in December, with the economy creating 199,000 jobs instead of the expected 400,000, the rest of the report was very encouraging.
The unemployment rate fell to a new post-pandemic low of 3.9%, while the labor force participation rate and employment-to-population ratio improved. More importantly, wage growth has been much stronger than expected, adding credence to the narrative that companies are starting to compete for scarce workers.
All of this paints a rosy picture of the labor market, despite the lack of non-farm payrolls. Markets have responded by betting that the Fed will be forced to step up its normalization plans to prevent strong wage growth from fueling inflation. The implied probability of a rate hike in March now stands at almost 90%.
In total, markets are now anticipating three Fed hikes for this year and a level playing field for a fourth.
Yields go up but the dollar won’t obey
When rate traders bet on faster Fed rate hikes, it usually benefits the dollar as yield differentials widen to its advantage. However, that was not how it turned out on Friday. As US yields soared, the reserve currency did not follow the scenario and instead lost ground.
One explanation for this dichotomy is that short-term European yields also jumped, more than their US counterparts for that matter. Inflation in the eurozone hit a new high of 5% in December, fueling bets that the European Central Bank will also kickstart interest rates soon. Money markets advanced the ECB’s first minor rate hike until October of this year.
Admittedly, this speculation seems excessive. While European inflation has really taken off, the labor market has not recovered, so there is no reason to fear an inflationary wage-price spiral. The last thing the ECB wants is to raise rates too quickly and put additional pressure on heavily indebted economies like Italy, risking shocking the bond market and undoing years of hard work.
Therefore, relative monetary policy still argues for a decline in the euro / dollar as markets have the opportunity to fully assess a fourth Fed hike this year, while it is extremely unlikely that the ECB presses the rate trigger in October. The main risk associated with this view is “spike in inflation” in America, which sees traders retracting bets for aggressive Fed tightening.
Actions under pressure
Stock markets have been under pressure since the start of the year, trying to accommodate the negative effects of rising interest rates. Most of the damage has been concentrated in the tech sector which is most sensitive to higher returns, hence the reason the Nasdaq lost 1% more on Friday to end the week 5.5% lower.
Valuation has been judge and hangman in the stock markets lately. The surge in yields has seen the scandalous multiples of many companies compress to reflect reality, with riskier names hit the most, with investors favoring stable earnings over future promises.
Whether investors continue to position themselves for a world of higher rates may depend on the events of this week, in particular Wednesday’s latest US inflation report and President Powell’s testimony to Congress. The earnings season will also begin on Friday with the major US banks.