You wouldn’t know it by the Dow's
(INDEXDJX:.DJI) muted reaction but Friday’s employment data was not only much weaker than expected, it was one of the worst months since the economy emerged from the recession. The number that matters, private payroll gains, was a mere 95,000 -- the third weakest month of job growth since the data turned positive in 2010 and well below the average of 177,000 since then. The real freaky number is the participation rate which fell to 63.3%, the lowest since 1979 as 500,000 dropped out of the labor force. Combining the first three months together gets you 504,000 jobs for the first quarter, which is 283,000 jobs below Q1 2012.
Last week in Amid Stock Market Euphoria, the Smart Money Is Fading
I suggested that this was a make or break week for the bond market, and that despite all the bullish cross currents, that falling bond yields were sending a different message regarding the health of the economy. I stated the following:
Next week we will get the two most important monthly economic data reports in ISM manufacturing and non-farm payrolls. In addition we will get meetings from the newly uber-dovish Bank of Japan which is expected to launch an aggressive QE campaign, as well as the ECB, which is dealing with its own set of issues. With the 10-year sitting right on top of the key 1.85% pivot you might say this is one of the most important weeks of the year for bond market investors. If the 10-year can hold this 1.85% level amidst the stress of what appears to be improving economic data, a breakout in stocks, and exceptionally easy global central banks, you have to believe that the bond market is reflecting a dynamic that no one yet sees.
The 10-year yield settled Friday’s wild session at 1.71%, well below the key 1.85% pivot. The long end led the charge trading with a massive flattening bias as 10s/30s narrowed by nearly 20bps on the week taking back all the steepening that had occurred since the beginning of the year. CRT’s Marx Bowens, who I know to be a very smart bond trader, was quoted in Bloomberg saying, "Clearly the marketplace has been short duration. Some major institutions made the decision at a very high level that rates were trending higher for the next couple of years and they had to be positioned that way."
Unfortunately these high level executives of these major institutions don’t read this page
on Minyanville because I’ve mapped this trade with precision since my year-end 2013 Bond Market Prognostication
I think 143-00 is a huge number. It was a climax top in 2008. It was made support in 2011 and 2012, and it’s very close to two standard deviations in the rising channel. If violated to the downside, a bond market top could be in place, but don’t expect it to go quietly; it will likely put up a tough fight.
US Bond Futures (Weekly)
On February 19 in Bond Market Convexity Objects in Mirror Are Closer Than They Appear
, I tightened up the analysis:
Clearly the market has recognized the 143-00 pivot as the consolidation is in its third consecutive week and there's no doubt that a bull/bear battle is underway as participants jockey for positioning. The key factor for me in determining who wins this battle is whether economic growth and the demand for credit is increasing, or whether recent optimism is simply a function of rising stock prices on the back of a depreciating yen.
And on March 4 in Bond Market Strength Forged in the Fires of Adversity
I broke down the bottom line that led me to believe that the bond market did not share the equity market’s economic optimism.
...the bond market has been given every opportunity to push yields higher, not only contending with the equity bullish data, but also increased pressure coming from the tapering debate, Fed exit talk, as well as more specific market dynamics such as MBS convexity selling that I have been addressing in recent weeks. With bonds holding their gains in the face of a full recovery in equity markets, the bond market strength is even more impressive.
The 143-00 level wasn’t a guess; it was forged by the fires in 2008 and 2011. Back-testing this area was not a coincidence and the market is telling you this level is real. In last week’s rally price stopped where you would expect it to find resistance at the first standard deviation of the regression line but if we are indeed making 143-00 support the rally could take us to at least back to 150-00 and new highs are likely. At this low level of interest rates a move of this nature has dire economic implications.
In identifying the 143-00 as a key pivot I never got caught up in the nonsense being peddled by Wall Street and allowed market price to do the talking. For the entire quarter I watched the bond market test this level, then intensely vibrate and hold the pivot, making it support as risk assets soared to new highs. Then over the past couple of weeks bonds have rocketed higher in what appears to be an impulsive move aimed at challenging new highs.
This is how I bridge technicals with fundamentals and is the essence of how I employ ex ante analysis. I am not simply mapping the bond contract for the sake of charting the direction of price; I am utilizing the technicals in order to extrapolate the direction of the economy. Holding 143-00 is a major statement by the bond market, and a move towards new highs, which will push long term interest rates to new lows, implies a sharp deceleration in growth in the months and potentially years ahead.
On Good Friday when the markets were closed for the long Easter weekend the BEA
released February Income and Spending. The numbers were generally better than expected on a sequential basis as the data smoothes out the distortions from last year’s increase in dividends to avoid 2013 tax hikes against higher payroll taxes that kicked in this year. However a number that gets overlooked but carries a big weight in the trajectory of economic growth is the YoY growth rate in personal consumption.
The February reading of YoY personal consumption growth came it at 3.3% following a January level of 3.4% and December of 3.6%. As you know personal consumption is a big data point because at 70% it represents the largest component of GDP. Over the past 50 years of data the YoY growth in consumption has averaged about 25bps above YoY nominal GDP growth which demonstrates this tight relationship.
This decelerating consumption growth is notable because since 1963 consumption has rarely dipped below 3.5%, and each time it did it coincided with a recession. This is a troubling development and not only suggests the 3.5% nominal GDP growth rate in Q4 2012 was not the anomaly many economists believe it to be, but also corroborates what the bond market has been discounting.
I think what gets lost in the larger economic debate is that this deleveraging cycle is not so much about correcting a debt and real estate bubble but rather correcting a consumption bubble. Consumption can be financed by three sources: income, savings (net worth), and credit. Since 1980 consumption as a percent of GDP rose from 62% to the current 71%. This consumption growth was largely financed with debt which rose from 50% of GDP to nearly 100% in 2008 and net worth which, due to stock prices and real estate values, rose from 3x GDP to 4.5x at the peak in 2008. The consumption bubble manifested itself in a massive current account imbalance which went from a zero balance in the early 1980s to a deficit of over $200b at the height in 2006. Consumption, Household Debt, and Net Worth Vs. NGDP
Consumption and household debt didn’t just rise in relation to the size of the economy, they also rose as a percent of income. Credit was used to subsidize income in order to increase spending which in turn drove GDP growth. For decades the US economic growth engine that we all love to brag about has really just been an exercise in consuming stuff we didn’t need with money we didn’t have. This generational trend is now in reverse and potentially so massive that it transcends monetary and fiscal policy.
Personal Consumption and Household Debt Vs. Income
These relationships between consumption and debt are on a track to revert to more sustainable levels vs. income. I believe this is what the bond market is telling us. Just as the 10-year yield is tightly correlated with nominal GDP growth so too is it tightly correlated with consumption growth. Over the same 50-year period consumption growth has exceeded the 10-year yield by 50bps. Based on the historical relationship a 2.00% 10-year is discounting longer term consumption growth of just 2.5% implying a 2.25% nominal GDP growth rate. These levels of growth are signaling a chronic recessionary environment. PCE Vs. GDP and 10-Year Yield
As households continue to delever debt levels from 100% of income back towards 70%, consumption growth will be under significant pressure. You can see how in this type of shift in the way households finance consumption that these meager growth rates are not so far-fetched. Instead of concluding that the bond market is being manipulated by the Fed, which is driving interest rates to abnormally low levels, perhaps we should be looking for reasons why a 2.0% 10-year might actually be fair value. There is nothing unusual about these falling yields against a backdrop of decelerating consumption growth, and the impulsive rally off the 143-00 pivot should not be underestimated for what it implies about the economic reality.
The 2008 financial crisis was not about subprime mortgages or the failure of Lehman Brothers; it was the climax in a three-decade-long consumption bubble. The Fed’s monetary policy aimed at stimulating aggregate demand is clearly focused on stimulating consumption by making credit free and by reflating net worth. However it’s not working. You don’t correct 30 years of excess with a few years of zero interest rates and QE.
The game of financing consumption growth with credit and assets is likely over, and going forward, income is going to bear the cost. As such, the respective relationships between spending, income, and economic growth are bound to revert to more sustainable levels. This will likely coincide with a very low level of economic growth for the foreseeable future and continue to foster an environment of very low long term interest rates.