Jan 07, 2011

Bigger than Unemployment: Today’s News that Really Mattered

By Andrew Mickey, Q1 Publishing

The latest unemployment figures were released today and the results - as has been the case for nearly three years - were disappointing.

The market was expecting gains of 160,000 jobs. The Department of Labor estimated actual gains of 103,000.

In addition, more than a half million Americans gave up looking for work. So they’re no longer “unemployed.” And the official unemployment rate fell from 9.8% to 9.4%.

After 20 months of unemployment above 9%, the reception of the news was muted. Stocks, gold, oil, and copper, were essentially flat.

Behind the market indices reported on the evening news though, there was a real reaction in the markets (specifically, the market we consider the most important one in the world) that is set to have a continued impact on your portfolio in the short- and long-term.

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Keeping the Music Playing

The real impact of this unemployment report is playing out in a market most investors never watch, but affects everything from housing prices to economic growth – the bond market.

The unemployment report sent the bond market into a burst of activity. At first interest rates jumped following the news. By the end of the day, interest rates fell below yesterday’s closing levels.

The reason for the volatility is simple. Fed chairman Bernanke confirmed the bond market’s expectations not long after the report was released. He spoke about stronger economic growth in 2011, yet warned of “persistently high unemployment” and that it wouldn’t “normalize” for four to five years.

In other words, near-zero interest rates are here to stay for a long time to come.

Before the announcement, the interest rate futures market priced in a 98% chance the Fed would hike short-term interest rates before the end of the year.

After today’s report and Bernanke’s comments, the futures market is now pricing in a 58% chance of a short-term rate hike.

In the short-term, this reaction is a good thing.

It’s the Liquidity, Stupid

The rallies in bonds, stocks, and hard assets to this point have been fueled by low interest rates.

The free money spigot has been kept open and anytime there is a liquidity crunch – or at least fears of one – central banks have responded by dumping money on the markets.

The TED Spread, which is the spread between the rates on interbank loans and U.S. T-bills, is the ultimate indicator of liquidity. The spread increases when liquidity dries up and it falls when the liquidity increases.

Throughout the credit crunch of 2008 and each significant correction and rally in the market since, the TED Spread signaled the underlying driver of each move every time.

The five-year chart of the TED Spread below shows today’s news signals clear sailing ahead:

The chart shows liquidity is the most important factor driving the markets.

The stock market’s fall from all-time highs in 2007 to lows in 2009 coincided with a sharp decline in liquidity.

The market rally that kicked off in 2009 coincided with a sustained increase in liquidity.

The correction last summer coincided with a sudden and short-lived decrease in liquidity.

Liquidity is the most important factor in the markets today. And considering today’s news sparked no change in the TED Spread, we’re inclined to expect no significant problems in the near-future. The worst-case scenario would be quick, sharp correction to keep stocks from getting too hot.

No Gain, No Pain

Of course, the short-term gains will be offset with plenty of long-term pain.

One big pain will turn out to be that more and more investors are getting sucked into the bond market at, what history will likely prove, is the worst possible time.

The liquidity-fueled rally has extended the bond rally far longer and deeper than it should naturally have. This week the good times continued. Bloomberg reports bond issuance has increased to the highest weekly level on record.

Another big pain will be the steady devaluation of currencies. Although the dollar is coming off a strong showing in 2010 (the U.S. dollar index increased last year by 2.4%) and is poised to continue higher if only because the top alternatives – the yen and the Euro – are simply more fundamentally flawed than the dollar.

Tied to that will be more inflation. Whether it ever shows up on official inflation barometers, you better believe it’s here. Food, oil, and commodity prices have climbed across the board. The Fed’s short-term feel-good liquidity party will keep them on the uptrend.

Finally, the interest rate reckoning day will only be stronger and faster.

With all that in mind, it’s important to look at what today’s unemployment report is – a monthly unemployment report. And it’s impact of keeping the free-money liquidity lubricant driving asset values even higher over the short-term.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

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