Market Overview

Today's Dysfunctional Markets: Good Economic News Triggers Immediate Headwinds

A much better than expected June Nonfarm payrolls report, released prior to the market open on Friday, sent stocks surging and unleashed a host of volatility in other markets.

While the news was good, it also had the effect of significantly exacerbating systemic headwinds to the economy in the course of a single trading session.

In the wake of the upbeat employment report, the U.S. Dollar, crude oil and Treasury yields all moved aggressively higher and the effects will soon be rippling through the U.S. economy.

Threat Assessment: Interest Rate Velocity a Major Concern

Of particular concern is the rapid rise in yields on long-term U.S. Treasuries, which is putting upward pressure on interest rates. While the economy may be able to support higher rates over time, it is the velocity of the move in U.S. Treasuries that is very disconcerting to investors right now. What is happening in the markets can be traced back to the Federal Reserve's unprecedented and non-traditional monetary policy in the wake of the financial crisis.

Ever since the collapse of the mortgage market, the central bank has held their benchmark interest rate near zero in order to encourage liquidity and capital formation within the economy. The Fed has also been engaging in near-perpetual quantitative easing whereby it purchases financial assets using newly created money in order to add liquidity to the system. Among the assets that it has been purchasing in massive quantities are U.S. Treasuries.

Investing Today: Fundamentals Take a Backseat to Fed Policy

The Fed's constant buying has put upward pressure on prices, causing yields to collapse. For years now, investors in command of trillions of dollars have been piggy-backing on the moves made by the Fed. Since the central bank was buying Treasuries, investors did the same, pushing yields ever lower.

Zero interest rate policy and quantitative easing has also encouraged investors to pour money into the stock market in a desperate search for returns above the inflation rate. The problem is that private capital has not been allocated based on economic fundamentals, but rather in reaction to Fed policy.

Therefore, when policy shifts, so too does capital. When Fed Chairman Ben Bernanke suggested that the central bank may begin tapering its quantitative easing program at the September FOMC meeting, naturally, investors started to flee the Treasury market. In turn, this has triggered a huge upswing in yields in a very short period of time. This rapid shift in capital has the effect of causing a rise in interest rates, which will be a drag on the real economy.

Positive Economic News Triggers Fundamental Headwinds

The June Nonfarm payrolls report showed that the economy added 195,000 jobs last month, which was in-line with the gains recorded in May. Economists had been expecting an increase of only 166,000. Private payrolls for June rose 202,000 versus expectations of a 180,000 job increase. This is certainly good news. As stocks rose on Friday, however, money poured out of U.S. government debt as investors quickly inferred that the upbeat economic data will cause the Fed to begin tapering its bond-buying program in September.

The iShares Barclays 20+ Year Treasury Bond ETF (NYSE: TLT), which tracks the prices of long-term Treasuries, plunged 3.41 percent on the session -- a massive move. In addition, the PowerShares DB US Dollar Index Bullish ETF (NYSE: UUP), which tracks the performance of the greenback versus a basket of foreign currencies, surged almost 1.50 percent on the day. Although a rising dollar is not necessarily bad, it is a deflationary phenomenon and could become an economic headwind in the future.

The rise in rates, conversely, is sure to become a headwind very shortly. Over the last month alone, the 5-Year Note yield is up fifty-six basis points. Over the last year, it has risen ninety basis points. The 10-Year Note yield has surged sixty-three basis points over the last month and is up over 1 percent during the last 52-weeks. The 30-Year Bond yield has now climbed forty-four basis points over the last month and ninety-seven basis points over the last year.

In addition to the headwinds that this presents to the private sector, rising Treasury yields will also put significantly more pressure on the finances of our overly-indebted Federal government. The result will be more growth-limiting austerity and higher taxes. Needless to say, the political atmosphere is setting up to become even more fraught as these market forces play out.

Housing Recovery at Risk

Although the Dow rose around 150 points on Friday, the share prices of homebuilders were down sharply. Rising mortgage rates will surely be a headwind for the housing market -- which was the epicenter of the collapse in 2008. Among the biggest losers on the session were Lennar (NYSE: LEN), Ryland Group (NYSE: RYL) and Meritage Homes (NYSE: MTH). Lennar shares fell roughly 4 percent, Ryland lost 5.50 percent and Meritage was down 5.60 percent.

The price action of other interest rate sensitive sectors is also pointing to investor concern. In particular, Real Estate Investment Trusts or REITs, have been under significant pressure as rates rise. The bottom line is that it is unclear whether the real estate market and the broader economy will be able to withstand the velocity and magnitude of the current rise in interest rates. This question will be something that investors will be grappling with more and more heading into the Fall.

Crude Oil Above $100 Despite Anemic Growth

Positive sentiment and increased risk appetite in the wake of the Nonfarm Payrolls report also sent crude oil surging on Friday. Prices are now at worrisome levels. NYMEX crude futures added a little less than 2 percent on the session and closed the week at $103.22. The move in crude was even more impressive considering the significant uptick in the U.S. Dollar on the day.

Because crude is priced in U.S. Dollars, a rise in the greenback tends to exert downward pressure on oil prices. It is very rare to see crude add 2 percent on a day when the Dollar is also surging to the upside. At current prices, investors must begin to consider the effects that higher gas prices will have on the slowly recovering economy.

A Self-Limiting "Quasi-Recovery?"

This is a headwind that simply cannot be mitigated. In the first-quarter of 2013, domestic GDP grew at a modest 1.8 percent -- yet oil prices are now sitting above $103. If the current trajectory persists, investors may soon be forced to factor in runaway crude prices when evaluating the economy's future prospects. Considering the current environment of sub-par growth and capacity utilization, it is not hard to envision crude trading above $150 if conditions continue to improve.

As a result, investors may be forced to confront an unfortunate reality as a result of rapidly rising rates and soaring oil prices: fundamental forces at work in financial markets may restrain any real improvement in economic conditions. Seemingly, what is gained in one area of the economy, such as the job market, is quickly being offset by headwinds in other areas and this phenomenon may prove to be a significant drag on future expansion.

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