Technicals at Play in Jobs Reaction

Friday's jobs report seemed, to many, to be right on consensus. In most of the headline figures, this is true. But the market's reaction was downright confused, with some markets trading like this was a Fed-dovish release and others like it is hawkish. I think what we are seeing is a cross current of technicals causing a dislocation. If so, there should be some good opportunities to come out of it.

What's happened the last three days since the GDP release, the FOMC meeting and today's payroll figures? Interest rates are higher for one. That might make you assume that the strong GDP report is causing investors to pull forward Fed hikes. If so, the weakness in stocks makes sense also. I would think that a higher rate environment warrants a lower P/E ratio on the market. The dollar is also moving stronger, which is consistent with the theory that hikes are being pulled forward.

And yet, the yield curve is steeper. This means that long-term rates have risen more than short-term rates have. This does not fit with what is being priced in to other markets. Few things are as reliable as the fact that Fed hikes cause the yield curve to flatten, usually because short-term interest rates rise by much more than long-term rates. So, if the market is trying to price in Fed hikes coming a couple months, the 2-year Treasury should be much more impacted than the 30-year Treasury.

When you see markets diverging like this, there are often opportunities, so it's worth considering what might be the explanation for this divergence. That might suggest a profitable trade.

I think there are two plausible possibilities. One is simply that various markets are blowing off some steam and these economic releases have just been the excuse. Stocks and high-yield had been running, rates were lower and the yield curve was flattening severely. Now all three of those are reversing. Perhaps it is nothing more than a pullback. But if so, and if you believe in the fundamentals behind the larger trend in all three cases, it would make sense to fade this move.

I think what is more likely is that we have a cross current of technical factors at play. Retail has been selling junk bond funds and now we're hearing many hedge funds are lightening up, particularly macro-oriented ones. Retail tends to overweight the correlation between rates and credit spreads, but in the short run the technicals can easily run together in this fashion. Many hedge funds have big profits in junk bonds, but have had mediocre years overall. We're hearing about a lot of profit protection trades going on. I am not as plugged into the stock world, but the same factors that affect junk bonds are probably impacting stocks as well. On top of this, I am hearing about hedge funds setting new shorts in long Treasuries. I think the combination of a breakout in rates with clearly stronger economics has emboldened these shorts.

The combination of these factors explains the movements we're seeing across asset classes. High yield and stocks show some weakness, the curve steepens, rates rise, the dollar rallies. But I get back to the fundamentals and what can I say with confidence.

• Stocks? P/Es should probably be somewhat lower, will revenue growth follow? Hard to say.
• Rates? Directionally, this is a difficult call. It depends greatly on how high the next rate cycle goes. I don't think it goes very high, but I don't have a ton of confidence in that view.
• High yield? There's no reason to think that the default cycle is about to turn over. The Fed can't really cause a big junk bond selloff unless it touches off a recession. That might happen, but it isn't imminent. I'd be a better buyer.
• Yield curve? I'm very confident that Fed hikes are coming and this will cause the curve to flatten. Short 5-years and buy 30-years. This is the third time over the last three months we've seen a 15-20bps re-steepening of the curve and every time its ground back down to make new lows. This is your best trade.