- Traders bet on faster Fed rate increases after solid jobs report
- Yields spike higher but the dollar cannot capitalize – euro flows?
- Stock markets take another hit as valuation rotation continues
Hot labor market
The US jobs market is approaching full employment conditions with impressive speed. Even though nonfarm payrolls fell short of expectations in December, with the economy adding 199k jobs instead of the anticipated 400k, 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 the employment-to-population ratio improved. Most importantly, wage growth was far stronger than expected, adding credence to the narrative that companies are starting to compete for scarce workers.
All this paints a rosy picture of the labor market, despite the shortfall in nonfarm payrolls. Markets reacted by betting the Fed will be forced to expedite its normalization plans, to prevent strong wage growth from feeding inflation. The implied probability for a rate increase in March now stands at almost 90%.
In total, markets are now pricing in three Fed hikes for this year and equal chances for a fourth one.
Yields spike but dollar doesn’t obey
When rate traders bet on faster Fed rate increases, that typically benefits the dollar as yield differentials widen to its advantage. However, that’s not how it played out on Friday. While US yields did spike higher, the reserve currency didn’t follow the playbook and instead lost ground.
One explanation for this dichotomy is that short-term European yields also jumped, more than their US counterparts in fact. Inflation in the euro area hit a new record of 5% in December, fueling bets that the European Central Bank will also get the interest rate ball rolling soon. Money markets have pulled forward the first minor ECB rate increase to October of this year.
Admittedly, this speculation seems excessive. While European inflation has truly fired up, the labor market hasn’t recovered, so there is no fear of a wage-price inflationary spiral. The last thing the ECB wants is to raise rates too fast and put additional strain on highly indebted economies like Italy, risking to shock the bond market and undo years of hard work.
Hence, relative monetary policy still argues for a lower euro/dollar as there is scope for markets to fully price a fourth Fed hike this year, whereas the ECB is extremely unlikely to pull the rate trigger in October. The key risk to this view is ‘peak inflation’ in America, which sees traders dial back bets for aggressive Fed tightening.
Stocks under pressure
Stock markets have been under pressure since the year began, scrambling to price in the negative effects of higher interest rates. Most of the damage has been concentrated in the tech sector that’s the most sensitive to higher yields, hence why the Nasdaq lost another 1% on Friday to close the week 5.5% lower.
Valuation has been judge and executioner in equity markets lately. The spike in yields has seen the outrageous multiples of many companies compress to reflect reality, with the riskiest names suffering the most as investors prioritize steady profits over future promises.
Whether investors continue to position for a world of higher rates could depend on this week’s events, particularly on the latest US inflation report on Wednesday and the testimonies by Chairman Powell before Congress. The earnings season will also commence on Friday with big US banks.
