Stocks finally took a breather last week, down about 1.5%, mostly due to a downdraft Friday that was “blamed” on a good employment report. Jobs increased by 295k in February and the unemployment rate dropped to 5.5% (although that was mostly due to a drop in the participation rate) and that, according to the pundits, means the timeline for a Fed rate hike moved to June from the previous expectation of a September hike. And apparently that means one should sell stocks and bonds as both sold off pretty hard on Friday. Of course, the press needs an explanation and with everyone focused on the Fed I suppose that is the most obvious one. But does it really make sense?

The February report was better than expected as the betting line was for a rise of only 225k but it wasn’t out of line with recent employment reports and in fact was slightly below the average of the previous 3 months. I didn’t see anything in the report that should have caused such a drastic shift in expectations for the first rate hike in over 8 years. In fact, taking in the whole of the economic data on the week, the trajectory of the US economy is, if anything, pointing a bit more south than just a few months ago. Most of the data last week was on the soft side of expectations and in some cases just plain soft.

The manufacturing sector is pretty obviously slowing, something being blamed on the energy sector but probably a bit more widespread than that narrow interpretation. The ISM report was less than expected and factory orders fell for a sixth consecutive month (which one might note has a starting date prior to the big drop in oil prices). That was backed up by the trade report released Friday that showed a drop in both exports and imports, the latter by a hefty 3.9%. Further confirming the slowdown was a third consecutive monthly drop in auto sales to a 16.2 million annual rate and a fall in construction spending of 1.1%.

On the consumption side of the economy the news wasn’t much better. Personal income rose 0.3% in January but spending slipped by 0.2%. Consumer credit expanded less than expected with the gain centered once again in auto loans and student loans. Revolving credit (credit cards) actually shrank by $1.1 billion. Meanwhile, Challenger reported 50,579 layoffs on the month, well above the 4th quarter average of about 40,000/month. Jobless claims were also higher than expected but still not alarming at 320,000.

The positive reports of the week were the employment report and the ISM non-manufacturing index which was slightly better than expected. As I said above the employment report wasn’t all that spectacular compared to recent reports and it had all the caveats that have accompanied the vast majority of the reports in recent years. Low quality jobs led the way with 59,000 new food service and drinking establishment jobs created on the month. The drop in the unemployment rate, as noted above, was primarily due to a drop in the participation rate back to near the lows of this cycle. The Household report in general was a lot less positive than the establishment survey in any case with only 96,000 more employed than last month and the number not in the labor force rising by 354,000.

Some of the weak data can be explained by prices. For instance, the drop in personal consumption expenditures turns into a real gain when the 0.5% drop in prices is taken into account. Indeed the PCE price index is up a mere 0.2% over the last year. One can even make a case for the price effect on factory orders where non-durables fell while durable orders rose (although the durables was led by airplane orders which are quite volatile). Those non-durables are the ones affected by energy prices. Likewise the trade report where petroleum prices are obviously affecting the import figures.

Taken all together, frankly, I don’t see where a lot has changed in either direction. The US economy has been growing at 2 to 2.5% for several years now and I see no reason to believe that is changing. It does look as if 1st quarter GDP might be weaker than 4th quarter, based on the data so far this quarter, but beyond that all I can say is that some of the nominal data is trending or starting to trend in the wrong direction. We could be headed for a bigger slowdown and in fact if we follow the template of other countries whose currencies have risen the last few years that would make some sense. But for now, there is little evidence of a big slowdown. As for a potential acceleration, the one area that might make that possible is the drop in energy prices, but there are some caveats to that. First is that our economy is a lot more energy efficient than it was say 10 or even 5 years ago. Falling energy prices won’t provide the same boost they have in the past. Second is that the drop in capital spending by energy companies appears to be starting to bite and is a decided negative in the short term.

So, with all that said, the movements in markets this week were, to me anyway, a bit mysterious. The economy, despite Friday’s employment report, does not appear to be accelerating. If anything, manufacturing appears to be slowing. Although inflation expectations have risen during the recent bond market correction, actual inflation is a completely different story. The Fed’s preferred gauge of inflation, the core PCE deflator, is ripping along at 1.3% over the last year, well below their target of 2%. (On a side note, why is inflation ex-food and energy considered “core” inflation? Call me crazy but food and energy – and housing – are core prices for most Americans. Here’s a radical thought: maybe the Fed should concentrate on stabilizing the prices of the necessities and let the luxuries fluctuate in price rather than stabilizing the luxuries and letting the necessities fluctuate.) Import and export prices are both falling. In short, inflation is not a problem right now and as long the dollar is rising that is likely to remain true.

So, given those facts, I can see why stocks might fall but the fact is that they didn’t fall until the employment report was released so the weak reports earlier in the week were basically ignored by the market. I can also see, to some degree, why the dollar might rise (it made an 11 year high last week) with the ECB talking down the Euro, China downgrading their economic outlook last week and seemingly the entire rest of the world easing monetary policy. But why did bonds fall? With weak economic data and inflation continuing to fall, it seems the more logical choice would be to buy bonds, not sell them.

On the demand side of the bond equation, individuals have been net buyers of bond funds this year, banks are hoarding them for capital and collateral reasons, speculators have moved from a net short position of roughly 400,000 contracts to about 200,000 contracts and commercial hedgers have moved from net short to net long. So there have been plenty of buyers but they don’t seem to be able to overcome the selling pressure. The question of the week is who exactly is selling US Treasuries and why?

I don’t know the answer to that question but I do have a guess – the Chinese (and probably other emerging markets as well). China accumulated a large cache of US Treasuries during the weak dollar period from 2002 until the recent dollar rally. They did that for a number of reasons but mainly to keep their currency from rising too rapidly against the dollar. Capital inflows were trying to push the Yuan higher and the central bank bought dollars and sold Yuan to maintain the crawling peg. Now those dynamics are reversing. Capital is flowing out putting downward pressure on the Yuan. (This same scenario applies to a lot of the emerging markets but on a smaller scale).

One might think that the Chinese wouldn’t have a problem with that – certainly other emerging market countries don’t – considering the recent devaluation of the Yen but there is a problem with allowing the Yuan to fall right now. Because it was cheaper to borrow offshore in dollars, Chinese companies have increased their dollar debts dramatically over the last few years. At least some of the upward pressure on the dollar is coming from companies trying to hedge their dollar exposure and Chinese companies are certainly part of that group. The problem for the PBOC is that if they let the Yuan fall right now, it might make their economy even worse than it already is as those dollar debts will just get more onerous. Until those debts can be refinanced into another currency, preferably Yuan, the PBOC has little choice but to support the value of the Yuan.

Ironically, to keep the Yuan from weakening too much (down about 2.5% against the dollar in 2014) the PBOC will have to sell dollars and buy Yuan to keep the currency in the band. In a sense the PBOC is selling dollars to the companies who want or need to hedge their dollar exposure. And by the way, the higher the dollar rises against other currencies the harder it is for the PBOC to control the Yuan and the more dollars they have to sell. And that’s where the Treasury market enters the picture. Those dollars the PBOC controls aren’t sitting in a vault somewhere. They are invested in Treasuries primarily so selling dollars requires them to sell the bonds.

This is all speculation at this point because we don’t actually know where the selling is coming from and won’t for many months. But it does make sense and would explain why Treasury yields are rising in the face of a stronger dollar and relatively weak economic data. Why exactly the selling intensified Friday is a mystery and it may be that there is more here than meets the eye. Friday could have been as much about shrinking dollar liquidity, which is certainly not confined to China, as it was any actual US economic data. That would also explain the fall in stocks and the rise in the dollar.

It is impossible to explain exactly why any market is moving beyond the most basic supply/demand equation. Falling prices mean the sellers are feeling more urgency than the buyers. As for their specific reasons for buying or selling, one can never know the minds of the millions of individuals and institutions trading worldwide. Whatever their reasons, the sellers had the upper hand last week. It will be interesting to see if more selling emerges next week. Every dip over the last few years has been a buying opportunity. Will this one be different?

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