Weekly Economic Update 03-24-2017

The Streak Has Ended
The broad equity markets have ended their 100+ consecutive run of days without a 1% or greater move down on Tuesday. The analysts will tell you not to worry, because this is a very positive sign for stocks. In fact, investors took that move down and the move down due to the London terrorist attacks as an opportunity to “buy the dip.”

Historically the analysts are right, in the years following a 100+ run like this, stocks generally perform well. What they don’t tell you is that historically these long up cycles usually happen in year two or three following a recession, not in year eight of the third longest expansionary cycle in history and second longest bull run for stocks in history.

Labor Market Slack Higher Than Expected
The Federal Reserve Bank of San Francisco came out with a paper this week titled, “How Tight is the Labor Market?” that addresses the potential inaccuracies of the unemployment rate. Their research shows that the current unemployment rate may be 0.3-0.4% higher than the published rate due adjustments for an aging population. Keep in mind the FOMC is raising interest rates because they believe they have met one of their mandates of bringing the economy to full employment.

In other related employments news, the number of people filing for unemployment claims increased this week. The bigger news is that every year the government goes back and adjusts the data for the unemployment claims over the past five years. The adjustments show that claims are still very low, but not as low as previously recorded. Even though prior claims were revised and there was an increase in claims this week, it’s not until claims break 300,000 that panic will set in. With retailers planning to close stores this year, it should be expected that initial claims will increase in the weeks to come.

Real Interest Rates are Negative
Within the minute after the FOMC announced a rate hike last week, precious metals, commodity producers (miners), and Treasury bonds ETFs made a sharp move up. This was somewhat unexpected as usually a rate hike leads to decline in those sectors. The reason sectors moved up is because real interest rates went negative.

In the simplest of form, if you take the prevailing interest rate (10-year Treasury yield at 2.6%) and you subtract the inflation rate (CPI is at 2.7%) you get negative 0.1%. Meaning if you invest your money in a Treasury bond, one year later your purchasing power has declined due to inflation. When this happens, it is bullish for precious metals, commodity producers and Treasuries, which is why they all have moved up since the last rate hike.

Why the Fed is Hiking
The Fed hikes short term interest rates if they think the economy is growing too quickly or may grow too quickly. By hiking interest rates, they are just putting their foot on the brake to keep the economy and inflation from getting out of control. One of the ways the Fed gauges their decision to raise or lower interest rates is through the output gap. The output gap is the difference between the potential output and the actual output of our economy. Here’s an example:

An employee is working 4 hours a day but would like to work 8 hours a day. This would be viewed as economic slack, since the employee has the potential to work more hours.

Let’s say that employer only has 4 hours of work for their employee, despite the fact the employee would like to work more hours. In that case, there is no economic slack because the employee is working up to the employer’s limit.

The fear the Fed has is that when you have an economy at full employment, according to their data, and the potential output is equal to the actual output, again according to their data, the only likely outcome is that the economy is going to expand faster than the potential which will lead to high inflation. The proper move for the Fed is to raise interest rates and remove accommodative policies of years’ past.
This makes sense when the actual out moves upward to the point of the potential output. Or in the example, our 4-hour employee now has 8 hours of work because the employer had greater demand. As demand continues to increase from there, the economy starts to overheat, because the employer either has to hire additional employees or pay overtime.

Based on where our economy is currently, the potential output has fallen to meet the actual output. The Fed only sees that potential and actual output are equal. They do not factor how the economy got there; all that matters is that potential and actual output are equal.

What it tells us as investors is that the Fed has given up that the economy is going to further expand. Even their own projections show GDP growth over the next 4 years at less than 2% per year. That’s very weak.

In a sense, the Fed has thrown in the towel and given up. If you are not convinced, recently James Bullard of the Federal Reserve Bank of St. Louis concluded that the economy has reached equilibrium growth rate at 2%. Their only course of action is to tighten the money supply and hope the real economy grows. If it does not, and it does not appear that it will, they have made a huge mistake that will put us into a deep recession.

Client Update:
As I mentioned last week, last Thursday and Friday I invested 25% of the available cash each day in to gold and silver mining ETFs. I believe based on momentum and price movements that the greatest upside potential is in this sector.

Monday and Tuesday miners went out and outperformed the broad equity market over the same period. But when they failed to break over their 50-day moving average, a point that has been a problem for prices to break through, I knew prices would come back down a bit. As a result, I suspended the systematic purchase to leave myself options with the remaining cash.

Over the next three days’ prices would fail to close over their 50-day moving average. Prices have moved back down to the bullish trend line and have held the last two days. Based on the recent volume, it looks like a trend change is coming, which would suggest prices should start moving up next week. This will be covered in more detail in the video.

At this point I will likely hold off on any further trades in until prices start moving back up.

I have a hunch that the 21-day moving average will move up over the next trading days to confirm prices are headed up further. This should bode well with the 50-day moving average that should start trending down over the same period, meaning it should get easier for prices to retest and hopefully break over their 50-day moving average. A close over the 50-day moving average should be very bullish for miners.

Beyond that interest rates are falling and I believe they will fall quite a bit more in the future. More on that in the video.