Covenant Weekly Synopsis as of November 6, 2015

November 9, 2015

Developed world equity markets punched higher by about 1%, with domestic stocks recording their sixth consecutive week of gains. Chinese stocks rocketed up more than 7% entering a new bull market, though they remain more than 25% below their mid-summer highs. Following a strong October employment report, expectations of a December rate hike jumped (see below) and US Treasury yields rose (the yield on the UST-10 year reached 2.33%, the high end of a 2% – 2.5% trading range established in May). Expectations of higher rates caused the US dollar to soar 2.3% on the week, pushing the global reserve currency up more than 10% on the year. The prices for precious metals (gold -4.6%) and crude (-4.4%) fell on the week. Additional market detail can be found here.

Labor Market Tightening

The labor market report for October, released last week, was unequivocally strong across multiple dimensions:

  1. Unemployment rate declined to 5.0% (from 5.1%)

  2. U-6 underemployment rate fell to 9.8% (a seven-year low)

  3. Hourly wage growth increased to 2.5% year-over-year (six-year high)

Following the release of the report, the market rerated the probability of a December interest rate hike to 68%, nearly double the odds from a month ago.

Will the Fed raise rates in December?

Over the last several years the Fed has refrained from raising rates citing a weak labor market. In spite of evidence to the contrary, in September the Fed did not raise rates for a variety of different reasons: economic weakness abroad, a struggling domestic energy industry, the strong dollar and high market volatility (particularly in China).

While little has changed with regard to the international demand, the US dollar or the energy sector, the strong employment report has largely been interpreted as a “green light” for the Fed to raise rates in December. Absent, weak economic data between now and the FOMC December meeting, the market expects the Fed to raise rates. As such, this next meeting will be a good yardstick for measuring Chairman Yellen’s reputation as a fiscal dove. I hope and expect the Fed to raise rates. I am less concerned about the impact of a 25bps rate increase on the economy than I am about the Fed’s loss of credibility if they don’t raise rates. The former is manageable – the latter could be calamitous.

Economic Data Release Summary

The US ISM manufacturing index slipped to 50.1 (from 50.2) as weak global demand and a strong US dollar continue to weigh on US-based manufacturers (note that a reading below 50 indicates the sector is contracting). On the other hand, the US ISM non-manufacturing index increased close to a decade high at 59.1 in October (from 56.9 in September). While there is little reason to expect the manufacturing sector to rebound in the near future, the strong reading from the non-manufacturing index indicates that the services sector of the economy is expanding at a healthy pace. On this note, last week’s data showed a nice uptick in private sector credit expansion: revolving credit (i.e. credit cards) grew by 6.7% (on a 3-month annualized basis; commercial banking credit rose by 8.5% (on a 3-month annualized basis); auto loans jumped 1.4% month-over-month in October; and there was an uptick in residential and commercial real estate lending.

Be good,