Good Numbers, Bad Results

This morning, we received the highly anticipated May jobs report.  The results themselves were quite solid, which ended up presenting a problem for stock and bond markets.  Yesterday, thanks to a combination of sectoral rotation and bargain hunting stocks were able to largely recover from their early declines.  This morning, not so much…,

The employment report was indeed a bit of a stunner.  Nonfarm Payrolls rose by a whopping 172,000, well above the 88,000 consensus[i] estimate.  Even more surprisingly, April’s figure was raised to 179,000 from 115,000, and the two-month revision of +93,000 implied that March was raised by another 29,000.  Wow.  (Traders on IBKR Prediction Markets got it right when they expected an increase of more than 100,000.)

Just a few months ago, the prevailing opinion was that the Federal Reserve would be dealing with an uncomfortable dilemma that pitted both parts of their dual mandate against each other.  The jobs market was perceived to be weakening sufficiently to require Fed intervention, but inflation remained above their target.  The war in the Persian Gulf seemed to exacerbate that problem, with price pressures weighing more heavily on the dual mandate than weak employment.  That is why we have seen rate cut expectations evaporate and morph into expectations for a hike.  Today’s report removes any conflict.  If labor is strong and the stalemate in the Strait of Hormuz continues to bring price pressures, that removes an obstacle for rate hikes. 

Fed Funds futures reacted accordingly.  Yesterday they had priced in a 67% chance for a hike by December; today they are pricing in 100% plus a 7% chance for an additional hike before year end.  (IBKR Forecast traders are less convinced, with a midpoint of $0.52 for “Above 3.875%” on the December contract.)  That raises the effective Fed Funds rate by about 11 basis points, which is being fully reflected in 2-year Treasury yields.  Longer rates have risen by less, though.  The yield curve flattened because a Fed that is willing to raise rates demonstrates a greater willingness to fight inflation, and that is moderating the long-term inflation expectations that influence longer-term rates. 

Stocks have been consistently able to shrug off expectations for higher short-term rates for several weeks.  So, why are they reacting so negatively today?  The difference appears to be a change in market psychology that began yesterday.  It was clear that institutional investors were rotating into non-technology sectors of the market.  We noted that at noon yesterday, all 11 industry sectors other than Technology and Telecommunications were trading higher.  Large institutions were reallocating, rather than outright selling.  Meanwhile, individuals and aggressive institutions were buying the early dip, which allowed tech to recover a large percentage of its losses.  The S&P 500 (SPX) ended 0.41% higher on the day, and even though the Nasdaq 100 (NDX) closed 0.53% lower, it was well above its worst levels of the morning.

Today, however, the selling is so far unrelenting, with SPX down over 1.5% and NDX flirting with a 3% loss just after noon ET.  Small caps performed very well yesterday, with the Russell 2000 (RTY) rising by 1.45%; today they are down by nearly 2.5%.  Higher interest rates are not a friend to small caps.  Yet we still see evidence of further rotation into defensive sectors.  Even though NYSE decliners are outpacing advancers by about 3:1, we see consumer staples, healthcare, utilities, and real estate trading higher.  The first two are strictly about defense, especially when we have seen data that consumers continue to be well-employed.  The latter two are a bit curious, since utilities and real estate are rate sensitive, but they do reflect a preference for diversification and lower volatility today.

Today’s swoon all but assures us that SPX’s 9-week winning streak will be broken.  As we noted earlier this week, we’ve had more down weeks than up, by the way.  Nine seems to be the “magic” number for ending SPX streaks, since Wednesday’s decline broke a 9-day winning streak for that index earlier this week.  Does a couple of bad days presage a major turn?  Not yet – it takes more than a couple of declines in a three-day period to do that.  But after a stunning runup, where it seemed as though market declines had been all but outlawed, the risks of vertigo – as we saw yesterday in Broadcom (AVGO) – make hot stocks and sectors more treacherous than they seemed just a few days ago.

[i] Yesterday, we noted that the consensus estimate was 85,000.  Remember, these numbers are subject to change.