Key Points to Watch in Wednesday's FOMC Announcement

As of today's market close, the 30-day Fed Funds Futures have factored in a 95.4% probability of a .25 bps increase in interest rates when the Federal Open Markets Committee (FOMC) releases their December announcement at 14:00 EST on Wednesday.  This would mark the first rate hike since December of last year, and it would raise the Fed Funds rate to a target range of 0.50% to 0.75%.  The market would then settle rates around 0.63%, up from the current 0.38%.  The equities market expects the rate increase and has largely included it in stock prices. 

The actual monetary policy move is of little substance, tomorrow.  What traders and investors will be watching is the tone of the monetary policy announcement coupled with the statements and responses Janet Yellen provides in the post-announcement press conference.  That tone and her responses may significantly move the market heading into tomorrow's close.  Here are some points that we are watching.

• Commentary regarding unemployment.  The most popular number watched by the press and typically referenced by Yellen is the U-3 number which currently sits at 4.6%.  We know that she will reference that number and will likely cite it as an indication that the nation is at "full employment."  In past conferences, however, she has also made passing reference to both the U-6 number (9.3%) and to the Civilian Labor Force Participation Rate (62.7%.)  Those numbers paint a less rosy picture of the employment situation and we'll be watching how Yellen presents either of them in her commentary.
• The next major number we expect the Fed Chair to reference is the Inflation number.  It currently sits at 1.64%, slightly below the Fed target of 2.0%.  Since changes to monetary policy typically take approximately 6-months to have and effect, it's no surprise that the Fed will move ahead of their target.  It's like turning an ocean liner - it takes time to get the behemoth pointing in the right direction.  What we will be watching, however, is her assessment on the rate at which she expects inflation to increase.  This will offer some guidance as to how quickly rates will be increased in 2017.
• We anticipate some commentary, at least in the press conference, regarding potential tax and regulatory changes from the incoming Congress and Administration.  A somewhat adversarial relationship is developing between the President-Elect and the Fed Chair, and the latter has expressed concern in recent weeks over the possible inflationary impact the theoretical domestic policy changes will have on our overall economy. How she references this and the tone she takes will provide more clues into how swiftly the Fed believes they must move in raising interest rates.
• Some reference to "global economic headwinds" will likely be made, and that will most likely occur in both the announcement and in the press conference.  What we will be watching is whether those headwinds are perceived to be holding steady, increasing, or decreasing.  She may put this in the perspective of Brexit as well as the recent ECB announcement.  In the past, the economic conditions in Europe have caused the Fed to take a more cautious approach domestically.  Any improvement in the Fed's perception of those conditions will potentially signal a more hawkish economic policy in the US.
• We must pay careful attention to the phrasing of certain terms.  Once we have the announcement in hand, we need to compare the exact wording with the prior announcement.  Dropping a single word in a phrase can signal a fundamental shift in outlook, so we will need to scrutinize any changes to prior announcement specific to the rate at which the economy is expected to grow.

Current market expectations are for two rate increases in 2017.  These will most likely come in June and December.  At least, that's what the Fed Funds Futures have currently factored into pricing.  From a trading perspective, that is what we are attempting to anticipate.  A more aggressive monetary policy may signal a potential rate increase in the February or March time-frame, and we'll see stocks react accordingly.  Given the current inflation and unemployment levels, it's highly unlikely that the Fed will signal a slower rate of increase, although that more aggressive posture is a distinct possibility.

The final major consideration is something that will not be referenced in tomorrow's announcement, however it's something the markets will have to factor into pricing over the course of the next month.  There are currently two vacancies on the Fed's Board.  These will be filled by the President-Elect, and he will have the ability to make those appointments immediately following his inauguration.  Given that he has already expressed displeasure with the dovish policies set forth by Yellen, it's almost a given that his two appointments will have a hawkish outlook.  Their presence on the board will increase the likelihood of a more rapid normalization of interest rates than we've experienced thus far.  Expect this to be factored into market pricing the closer we get to the inauguration.

Happy Trading.     

Market Focus is on Tomorrow's Jobs Report

The Bureau of Labor Statistics will release the June 2016 Employment Situation report (popularly called the "Jobs Report") at 8:30 AM EDT tomorrow.  It's one of the most closely watched releases each month, and its trends have a significant impact on the Fed's monetary policy.  As you may recall, the May report issued last month stunned the financial world, showing a dismal increase of just 38,000 jobs in the Non-farm Payroll category.  When teamed with Brexit, the Italian banking crisis, and increased fears of recession in Europe - all factors Fed Chair Janet Yellen termed "headwinds" - the May report pushed any prospects of another Fed rates hike out into the distant future.  The futures market is currently projecting a near 0% chance of a rate hike in September, although it starts to climb ever-so-slightly in the fourth quarter.

Analysts do not expect such a dismal jobs report tomorrow, although the projections of 175,000 on the optimistic side to as low as 140,000 on the pessimistic side are still well under the levels needed to sustain economic growth.  The street is also expecting a slight rise in unemployment from 4.7% to 4.8%, and the expectation for hourly average earnings is an increase of 0.2%.

The June report, however, is being closely watched more as a harbinger of the economic outlook for the next twelve months.  Some analysts are now placing the risk of recession at 30% for the next year.  Given the turmoil in Europe and the impact that contagion can have in the States, I would categorize that 30% as very optimistic.  Even Janet Yellen, in the cryptic fashion typical of a Fed Chair, expressed concern last month: “Is the markedly reduced pace of hiring in April and May a harbinger of a persistent slowdown in the broader economy? Or will monthly payroll gains move up toward the solid pace they maintained earlier this year and in 2015?”  If, indeed, we see another month of anemic growth, prospects for recession will spike dramatically.

There's one important factor that will not manifest in this report, and that is the effect of Brexit on the US jobs market.  The data for the Employment Situations report closed on June 12, well before the UK vote to leave the European Union.  That vote sent shock waves through the world markets, including here in the States, and most companies are adjusting their capital plans to account for it.  Financial firms in particular are adjusting to the reality of prolonged low interest rates heading into 2017, and most companies with heavy European exposure are still trying to assess what the vote means for them and what adjustments they'll need to make in their 2017 capital plans.  Whenever there's uncertainty of that nature, companies become reluctant to add to their workforce.  None of this, however, will be reflected in this month's release.

The final data points that will be most interesting concern the Labor Force Participation Rate.  You've seen me write time and again that, in my view, this is the most accurate measure of the true employment picture, and the numbers released on June 3 were horrendous.  The rate dropped to 62.6%, setting an all-time record of 94,708,000 Americans out of work.  Analysts are expecting the rate to drop even lower in tomorrow's release.

What the report will mean for trading tomorrow is anybody's guess.  I've long since stopped trying to predict how the market will react to pre-open releases, especially when you have to factor in the contradictory effects of bad news being good for interest rate projections, but bad for future growth projections.  I've learned over the years to sit back on release days and let the market sort itself out over the first 30-60 minutes of trading.  Tomorrow will be no exception.

LMCI Comes in Weak at 4.9

The Fed released the January Labor Market Conditions Index this morning.  The LMCI, as we discussed yesterday, is comprised of 19 separate economic indicators that provide insight into the health of the job market.  With Unemployment continuing to fall and with optimism in last month's non-farm payroll index, expectations were high that today's LMCI number would continue to show improvement.  In yesterday's post, I said that I was looking for a value of 6.8 or higher to demonstrate strength in the labor market.  Well, we fell far short of that value.

The LMCI for January dropped to 4.9, a decline of 1.2 points off December's 6.1 value.  That drop confirms what we've been saying for some time, that the labor market is not as healthy as the unemployment number would lead us to believe.  In fact, the decline in January confirms the falling Participation Rate which is now at its worst level since the late 1970s.

What the low values in the LMCI are telling us is that, despite a drop in the Unemployment Rate - which I've already categorized in previous posts as a meaningless number - the other aspects of the job market are in terrible shape.  Hours worked per week continue to drop.  Wages continue to drop and annual merit increases are barely keeping pace with inflation.  Benefits, especially health care benefits, continue to skyrocket in costs to the worker.  The number of workers that are leaving the workforce prior to age 65 continues to increase.

Now, it's doubtful that the LMCI is having much of an impact on today's market decline.  As of this writing, we're trading near the lows of the day, but the entire day has been down due almost entirely to the standoff between the Eurozone and Greece coupled with the extremely poor trade numbers released by China last night.  Those two global constraints are having a far greater impact than the little known LMCI is likely to cause.

What we as traders need to take from this, though, is the warning that the labor market is not at all healthy.  We need to keep a very close eye on Average Weekly Hours, Average Hourly Earnings, Hiring Rate and Quit Rate, and Hiring Plans.  These will give us a much clearer view as to the conditions of the average worker in the US.  I'm expecting all of them to continue to worsen in the short term.

Labor Market Conditions Index (LMCI) - A One Size Fits All View of the Labor Market

A quick glance at the economic calendar for any month makes it clear that there are numerous data elements that detail aspects of the labor market.  Frequently, these elements directly contradict each other, which increases the difficulty in truly assessing the overall health and the overall trends that impact the workforce.  Take, for example, the two most popular measures of the health of the job market, the Unemployment Rate (currently 5.6%) and the Participation Index (currently 62.7%.)  The former has been trending downward for the past couple of years and is an indication of a healthy and growing workforce.  The latter, however, has also been trending downward since 2010, and is an indication of a large number of eligible workers leaving the workforce.  Both statistics are accurate to what they are intended to indicate, but neither accurately depict the health of the labor market in totality.

In an attempt to reconcile all the various economic indicators that touch some aspect of the labor market - and there are 19 such indicators - the Federal Reserve Board implemented a new index in mid-2014 that incorporates all of them.  The Labor Market Conditions Index (LMCI) provides a single at-a-glance number that factors in such diverse measures as the number of hours worked, wages, hiring rates, hiring plans, jobs that are hard to fill, and the rate at which workers transition between unemployed to employed.  There is a heavy weight placed on indicators that correlate well to each other, while those that diverge from other indicators are given less of a weight in the calculation of LMCI. Therefore, the jury is still out as to the effectiveness of this single Indicator of Indicators.

Indicators Included in LMCI

The LMCI for December - reported in January, 2015 - sits at 6.1, and it has been trending upward since August.  As you can see from the following chart, however, the health of the labor market is not accurately portrayed by the Unemployment Rate, which has been improving steadily for two years.  Neither is it accurately portrayed by the Participation Index which has been degrading steadily for four years.  Rather, the correlation of the wide range of indicators gives a much more meaningful view of the overall health of the labor market.  At least, that's the message it seems to portray looking at the graph of the last two years.  To put the current graph in perspective, LMCI reached a maximum value of 28.6 in September, 1983.  Its worst value was -43.3 in May, 1980.

LIMC - January 2013 to December 2014

The Labor Market Conditions Index for January, 2015 will be released on Monday, February 9 at 12:00 EST (15:00 GMT).  While the data that comprise the indicator go back to the early 1970s, the indicator itself is still in its infancy.  It remains to be seen how much of an influence LMCI will have on the overall market.  With this being the only economic indicator of significance being announced on Monday, however, expect it to have some influence over afternoon trading, barring any geopolitical developments coming out of Greece, Germany, Ukraine, or Russia.  While no consensus estimate has been released, I'm looking for a value of 6.9 or higher to indicate healthy growth in the labor market.  A lesser value would indicate that factors other than the Unemployment Rate are taking a heavier toll on the job market than is currently factored into the economic outlook.

A Neutral Fed Announcement Spooks Markets

The Federal Open Markets Committee (FOMC) issued a statement today that sent the US markets into a nose-dive.  With earnings across most sectors disappointing the markets throughout January, and with economic data being a further disappointment, speculation on the street was pushing estimates of interest rate hikes out into the September time-frame.  The Fed dispelled those notions this afternoon, and the Dow tumbled 190 points in response.

In today's release, FOMC stated, "Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy."  This is being interpreted as indicating a rate increase announcement no earlier than June, however it's not the dovish indicator the markets were hoping for.

It doesn't help that the FOMC's assessment of current economic conditions appears to be a bit rosier than those being seen by investors and traders.  Consider the following statements:

FOMC stated, "Labor market conditions have improved further, with strong job gains and a lower unemployment rate."  While it's true that unemployment has declined to about the 5.6% level, the Participation Index - a much more accurate measure of the workforce - has declined to its lowest level (62.7%) since 1978 and it continues to decline.  This would indicate that the number of eligible workers that are unemployed is increasing, not decreasing.  As to job gains, if you take Texas, Washington DC, Arkansas, and Utah out of the mix, the nation is actually shedding jobs at a rapid rate.  Almost all of the net national gains are coming just from the state of Texas.

Job Gains vs Unemployment

Here's the raw data just for Texas: Joint Economic Committee - Texas Economic Data

Next, the FOMC stated, "Household spending is rising moderately."  That's an interesting view, considering the Retail Sales number recently released was the largest decline experienced in 11 months.  If household spending is rising, one must question where they are spending it since it clearly wasn't in retail stores last month. 

They stated, "Recent declines in energy prices have boosted household purchasing power."  There's certainly more money in the consumer's pockets resulting from a decline in gas prices, however, as has been discussed several times over the past couple of weeks, there is no evidence that the consumer is spending that money.  In fact, there's evidence mounting that the decline in energy prices is about to have an extreme negative impact in the oil producing states that have driven the overall job growth since the recession.  With oil rigs closing, and oil companies starting massive layoffs, the conditions in states like Texas, Oklahoma, California, and North Dakota, among others, will quickly deteriorate.

Finally, FOMC stated, "Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices.  Market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable."  The problem with this statement is that both CPI and Core CPI are down.  This means that, even excluding food and energy, inflation is down. It makes sense, since wages are not increasing.  (Average in the latest release was a mere 1.7%.)  In other words, inflation is dropping, not because of energy prices, but because of a gradual softening of the economy as a whole.

What may have spooked the market the most is this phrase in their press release: "In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation." It's that "and expected" part that is disturbing.  Since their assessment of inflation to date is not accurate, the thought that they will react based on what they expect to happen implies a rate hike that will be premature in an economy that cannot tolerate it.

The only truly encouraging statement in the release is in the very last sentence: "The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."  This is, from what we can determine, the only acknowledgement that there are global economic forces that are providing extreme headwinds to US economic growth.  The strength of the dollar, a crumbling European economy, the renewed threat of a Greek Crisis, and the evaporation of Russia's economy are enough to give even the most bullish investor pause.  Add to that a reduction in the rate of growth in China and India, and there's the prospect of a US economy barely able to sustain forward momentum.

We're nearing the end of this quarter's earnings season.  There are definitely very strong sectors that will provide excellent trading opportunities in this uncertain market.  Aerospace, Auto Parts, and Utilities are all looking pretty good right now.  Keep an eye on the remaining announcements, and trade into strength (or short into weakness, if that's to your liking.)  For now, though, expect volatility to remain high given the uncertainty around when the Fed will decide to move on rates.