In the famous song of 1960s lyricist and polemic,Tom Lehrer, the song is about a relationship based on masochism, which certainly seems to be relevant to the FED and the stock markets. The song stresses how pain is pleasure:
I ache for the touch of your lips dear,but much more for the touch of your whips dear,You can raise welts like nobody elseAs we dance to the masochism tangoBash in my brain,and make me scream with painThen kick me once againAnd say we’ll never partI know too well,I’m underneath your spellSo darling if you smell something burning it’s my heart … hic … excuse me …Take your cigarette from its holderAnd burn your initials in my shoulderFracture my spineAnd swear that you’re mineAs we dance to the Masochism Tango
This is unquestionably the relationship stock buyers have with the Fed. Since Ben Bernanke’s 2010 speech at Jackson Hole (where he announced his desire for a portfolio balance channel), the market has been locked in a strange embrace as the FED plays theoretical roulette with investors’ portfolios. The FED promised more and more liquidity and urged the markets to keep adding risk as they created the vehicle of QE to smooth the transition from equity to debt. While investors rebalanced, corporations were busy borrowing money to fund stock buybacks and dividend dispersals. It’s been anything but more capex as consumer demand failed to meet the expectations of QE theory. Carl Ichan voiced his concerns over the immense amount of capital borrowed by corporations to sustain buyback programs.
Similar to the discussion Rick Santelli and I had last week, the vast amount of DEBT that has piled up with zero interest rates is the instigator and that debt is fine as long as it can be serviced. But as the global economy slows and corporate profits shrink servicing the debt becomes a problem. Moving from equity to debt has its price and Glencore’s recent distress is emblematic of the move from equity to debt at the top of the commodity cycle. As Glencore moved to swallow up the mining industry no deal was beyond its reach as long as it could be levered up. Now the bills are coming due and the debt pile has to be serviced with less revenue. As a result Glencore shareholders are being crushed as equity is being floated to pay down the enormous debt burden. Since corporations have borrowed to financially engineer P/E ratios as the FED raises rates, the cost of carrying the debt loads will become a negative for corporate profits moving forward.
Debt is fine as long as growth is strong enough to finance the interest rate costs. As Ichan made clear, this is what presently scares him and most probably the Fed. In 2011, I raised the issue of watching the private equity firms of Blackstone, KKR and Ochs-Ziff as indicators of the credit crisis ending and being a weathervane for market sentiment on the move back into equities. I would advise watching the private equity groups again as an indicator of market sentiment about an overleveraged debt situation for no investors utilize debt then private equity. Zero interest rates coupled with a portfolio balance channel results in a Masochism Tango.
***Tomorrow’s unemployment report has a few possible outcomes: The consensus is for 200,000 jobs growth and, most importantly, an average hourly earnings gain of 0.2%. If the data shows a strong report the possibility of an October Fed rate raise will become a greater probability. A strong report would be above 230,000 and at least a 0.2% gain in wages. But if the NFP is weaker, say 175,000 or lower, but AHE is greater than 0.3% then the Fed could still find a reason to raise rates. The average hourly earnings will be the most important variable because that seems to be the key for Yellen. A strong report will initially push equities lower but be patient for investors will probably buy a break for good news will provide some clarity about the economy and thus the FED‘s raising of rates. There seems little doubt that the hawkish voices won the day at the last FOMC meeting by posturing that a NO move by the Fed would be more deleterious for the markets than actually raising rates, which has proved accurate and has also emboldened James Bullard and Jeffrey Lacker.
The market is not afraid of 25 basis points but of the uncertainty promulgated by the Fed and other global central banks. Watch the yield curves and gold for an indication of market sentiment about the possibility of a FED rate rise. Presently the two key curves, the U.S. 2/10 and 5/30, are showing different concerns. The recent flattening in the 2/10 says investors are concerned about a Fed hike while the current steepening in the 5/30 is reflection of speculators concern about the confusion emanating from the Fed.
GOLD has been stuck in a range as it comes under pressure from selling related to the continued negative commodities story. However, investors buying are those leery about the uncertainty caused by muddled global central bank policies. Be patient as the ALGOs will react to the headline news as better jobs data will push rates higher, which rallies the dollar and sends gold lower. Do not enter the madness but wait for longer-term investors to send a more measured response.