The three variables weighing on the market have turned into tailwinds … but it appears to be for the wrong reasons … today’s awful jobs report … recession risk rising
There’s good news and bad news…
I’m going to try to butter you up with the good news first so that my eventual bad news doesn’t dampen your weekend.
Regular Digest readers recognize the term, the “Toxic Trifecta”
It’s what we named the combination of the surging 10-year Treasury yield, the strengthening U.S. dollar, and soaring oil prices.
These three variables have acted as wrecking balls for the stock market at various points over the last two years.
But yesterday, the 10-year Treasury yield – perhaps the most influential of the Trifecta on your portfolio – fell beneath 4% for the first time since February. And as I write Friday morning, it continues to crash. It’s at 3.83%.
Meanwhile, the dollar and oil have mostly decided to “Netflix and chill” this summer…
After hitting its 2024 high in April, the dollar has eased substantially. And despite the growing threat of a regional war in the Mideast, oil appears unconcerned, trading in the mid-$70s.
Given such easing, we must ask: Has the Toxic Trifecta become the Terrific Trifecta?
And more importantly, can we count on the continued bullish direction for each variable as we look toward the fall?
Let’s find out.
The 10-year Treasury yield has collapsed as the market looks toward softening economic data and interest rate cuts from the Fed
A surging 10-year Treasury yield means a higher discount rate, which lowers stocks’ current valuations. That’s a drag on lofty market prices.
Also, a higher 10-year treasury yield entices some investors to pull their money out of stocks to benefit from this “risk free” higher yield, which also puts downward pressure on prices.
Fortunately, “surging” is a remnant description from the Toxic Trifecta.
As you can see below, since hitting its 2024 high in late April, the 10-year Treasury yield has been on a steady decline, punctuated by yesterday’s drop beneath 4%. Today’s continued freefall down to 3.83% isn’t yet reflected in this chart.
It’s great news for interest-rate sensitive stocks, as well as tech/growth stocks that derive their valuations from discounting future earnings.
But can we expect this softening to continue?
Most likely, we can, but we should expect some volatility.
First, Federal Reserve Chairman Jerome Powell signaled his openness to a rate cut in September, likely with at least one more cut by the end of the year. Lower rates from the Fed supports “down” for bond market yields.
There’s also weakening economic data. Yesterday, initial jobless claims rose to 249,000 for the week ended in July 27. That was markedly higher than a Dow Jones forecast of 235,000. There was also the ISM manufacturing index coming in at 46.8. A reading below “50” indicates that manufacturing is declining. This ailing economy presents another win for “down” bond yields.
(We’ll discuss today’s jobs report later.)
Finally, there’s the potential for a geopolitical event that scares investors, sending them stampeding into the safety of bonds. Buying bonds drives prices higher, which pushes yields lower.
Put it altogether and “down” is the path of least resistance for the 10-year Treasury yield.
Next, the dollar continues to soften
A strengthening U.S. dollar creates headwinds for international companies that generate significant revenues overseas (due to currency conversion). This hurts earnings, which weighs on stock prices.
Keep in mind that between 40% – 50% of the S&P 500’s revenues are generated outside U.S. borders. For the tech sector, that exposure jumps to nearly 60%. So, you almost certainly have this dollar exposure in your portfolio.
But here again, the better adjective for the dollar in recent months isn’t “strengthening,” but “weakening.”
Below, we look at the U.S. Dollar Index on the year. It’s a measure of the value of the U.S. dollar relative to the value of a basket of six major global currencies – the Euro, Swiss franc, Japanese yen, Canadian dollar, British pound, and Swedish krona.
Like the 10-year Treasury yield, the dollar hit its high at the end of April, but has traded lower since.
Looking forward, what’s the most likely direction?
Here again, “down” wins the day.
This is more black-and-white. As the Fed begins cutting interest rates, the dollar becomes “less expensive” relative to other currencies (all things equal). This should continue to take pressure off the dollar as we head toward the holiday season.
Now, a surprise geopolitical event could result in a dollar spike. The world often turns to the U.S. (dollars and bonds) for safe harbor in times of chaos. But if we can avoid a Black Swan event, we expect continued cooling for the dollar.
Finally, oil keeps confounding investors by barely registering a heartbeat
Here we are, at the height of the summer driving season, and oil remains in the $70s.
Scratch that…
Here we are in the summer driving season – with the risk of a major regional war between Israel and Iran accelerating over the last few days – and yet the price of West Texas Intermediate Crude (WTIC) trades below $74.
But wait, there’s more!
Here we are in driving season, with heightened risk of global war, and, U.S. crude stockpiles have fallen for five consecutive weeks, marking the longest string of crude drawdowns since 2021 when there was a seven-week streak.
And yet, despite all this, oil prices are on vacation.
Below, you can see the price of WTIC on the year. Despite this week’s jump higher after Israel’s assassination of Hamas’s Ismail Haniyeh, we’re nowhere near 2024’s high, set back in April.
As we look ahead, there are no obvious catalysts that would drive prices materially higher.
Sure, OPEC might slash production. And the Israel/Iran and Ukraine/Russia conflicts could result in an oil production facility going offline. But such disruptions are not certainties.
So, on its current trajectory, oil prices appear likely to remain steady or lower as we move into the fall.
Putting it altogether, it appears “Terrific Trifecta” is, in fact, the appropriate update of “Toxic Trifecta”
So far, this is all great news.
Unfortunately, we don’t get to end our Digest here…
Let’s not forget why the Fed appears ready to cut interest rates… and the 10-year Treasury yield is crashing… and the dollar is headed lower… and oil can’t catch a bid…
Our economy is weakening to the point that we’re flirting with a recession.
Now, in his post-FOMC press conference on Wednesday, Powell sounded confident and assured about the strength of the labor market calling it “strong but not overheated.”
However, he also said, “we are watching labor market conditions quite closely. I would not like to see a material further cooling in the labor market.”
Well, this morning, we got “a material further cooling.”
This morning’s jobs report showed the unemployment rate unexpectedly shot up
Before I get to the data, let’s establish context…
First, remember that the June reading for the U.S. unemployment rate came in at 4.1%, up from 4.0% in May.
Also, don’t forget this tidbit from Powell when speaking in his press conference back in June:
FOMC participants expect labor market strength to continue. The median unemployment rate projection in the SEP is 4.0 percent at the end of this year and 4.2 percent at the end of next year.
Well, this morning’s labor report showed that unemployment jumped to 4.3%. In other words, unemployment has already pushed higher than where the Fed projected it would be sixteen months from now.
If you listen closely, you can hear the echo of “transitory inflation” floating on the wind…
Here’s CNBC with the details:
Job growth in the U.S. slowed much more than expected during July and the unemployment rate ticked higher, fueling fears of a broader economic slowdown, the Labor Department reported Friday.
Nonfarm payrolls grew by just 114,000 for the month, down from the downwardly revised 179,000 in June and below the Dow Jones estimate for 185,000. The unemployment rate edged higher to 4.3%, its highest since October 2021.
This jump in unemployment just triggered one of the most reliable recession indicators we have
The Sahm Rule.
Named after Claudia Sahm, former Federal Reserve economist and the originator of the indicator, the “Sahm Rule” compares the latest three-month average of the unemployment rate with the lowest three-month average over the past year.
When the latest three-month average is 0.5 percentage points higher than the lowest three-month average, the Sahm Rule triggers, suggesting the beginning of a new recession.
Since 1950, there has only one false positive (in 1959). But even in that case, the U.S. entered a recession six months later. The indicator correctly flagged the other 11 recessions.
Well, this morning, the Sahm Rule triggered as the value hit 0.53.
We’ve long been worried about a rise in unemployment that gets beyond the Fed’s control. In fact, it was one year ago in our August 31 Digest that we profiled the growing weakness in the labor market, writing:
Since 1990, each time the unemployment rate has climbed from a sub-4% level [to breach 4%], a recession followed…
Today, the unemployment rate clocks in at 3.5%.
Yes, this time could be different, but history shows that once the unemployment rate begins to tip the scale, it’s incredibly challenging to stop…
When the unemployment rate finally begins to rise, it’s not a long, gradual incline. Relatively speaking, it’s a fast, steep ascent that’s hard to control.
Meanwhile, the longer the unemployment rate remains this low, the tighter Fed rate policy is likely to be, increasing the odds they accidentally overdo it.
With today’s number already exceeding the Fed’s 4.2% unemployment rate projection at the end of 2025, it appears history is in danger of repeating itself.
Wall Street seems to believe so.
All three indexes are crashing as I write, with the Nasdaq leading the way, down 3%+. It’s now in correction territory, representing a 10% decline from its most recent high.
So, where does this leave us?
Well, it’s great that the Terrific Trifecta are here. But their arrival appears to be for the wrong reasons…
A bit like you having a day off work…but it’s because you’re sick.
So, are we in for a recession?
No one has a crystal ball. So, all we can do is respond with cool heads and discipline.
On that note, for months in the Digest, we’ve urged readers to ride this bull for as long as it’s climbing but be ready to mind your stop-losses if/when the market turns.
Well, you might be seeing some stop-losses trigger in your portfolio. Don’t ignore them.
Remember, return of capital is more important than return on capital.
We’ll keep you updated.
Have a good evening,
Jeff Remsburg
