Jobs Give Fed Green Light to Hike, but Bear Says Remember 1994

 | Mar 10, 2017 | 9:14 AM EST
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The first report of the Trump administration did not disappoint: Nonfarm payrolls were up 235,000 in February, more than the 200,000 expected by economists, and wages rose at the expected pace of 2.8%.

The euro weakened slightly versus the dollar immediately after the news as the data clear the way for the Fed to raise interest rates next week and possibly even quicken the pace at which it tightens monetary policy so as not to be left too far behind the curve. The single European currency then resumed its course higher, after a less-dovish-than-usual news conference by European Central Bank President Mario Draghi yesterday.

Despite the strong jobs report, the Fed's tightening could bring problems. Even while celebrating the bull market's resilience -- you can read all about the unloved recovery in The Street's special report on the eight-year anniversary of the bull market -- interest rate hikes that are too fast could spoil the party.

Renowned bear Albert Edwards, head of global strategy at Societe Generale, warned that the Fed has created a "massive" credit bubble that, when it bursts, will be devastating for the world economy.

"The 2007/8 Global Financial Crisis will look like a soft landing when the Fed blows this sucker sky high," Edwards wrote in a note on Thursday.

"Accelerated Fed rate hikes will cause tremors in the Treasury bond markets, forcing rates up, most especially in the 2-year -- just like 1994," he added.

Unlike some other market participants' version of events -- namely that the Fed was secretive over its moves -- Edwards recalls that the Federal Reserve was "telegraphing" a series of rate increases at the time and that people in the markets also anticipated multiple hikes. And still, the markets' reaction was very negative, with the yield curve jumping around 50 basis points almost on the spot.

"It was a bloodbath, especially for two-year paper," he said.

Just before the Fed rate hike of Feb. 4, 1994, two-year yields were trading around 100 basis points above the fed funds rate. However, that spread soared to 250 basis points in the three months after the one-quarter percentage point rate hike, and the yield curve between two-year and 10-year Treasuries flattened rapidly, Edwards noted.

"The key similarity with 1994 is that currently U.S. two-year yields at 1.35% still trade tightly to the current fed funds rate of 0.75%," he said.

If investors try to price in much more hawkish rhetoric from Fed Chairwoman Janet Yellen, then the same thing could happen again -- we could see the yield on two-year bonds rise toward that of the 10-year Treasury, just like it did back then, according to Edwards.

"If that happens and the U.S. two-year spread with German and Japan continues to soar, this will be like rocket fuel strengthening the U.S. dollar," he said.

A stronger dollar would be bad for U.S. exports but will not help domestic consumption because of protectionist measures that President Donald Trump wants to enact. It also could cause a slowdown in the rest of the world, as capital would be redirected to U.S. markets rather than stay invested elsewhere.

The jobs figure may tell the Fed a rate hike is a go, but the central bank still must proceed with caution.

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