One of the big questions facing markets today involves the relationship between the weather and the economy. There is no doubt that this has been a brutal winter (-15°C as I'm writing and it is already March!) and that it has contributed to the string of weaker than expected economic data out of the U.S. The trouble is we have no idea how much of the weakness is weather related and how much reflects a real softness in the underlying economy, hence calling into question the consensus view of a U.S. economic acceleration. While many analysts are trotting out estimates and models to answer this question, including one who estimates this has been one of the three worst winters in the past 60 years, the reality is we do not know. In the terminology we used when looking at stereo equipment in years gone by, the signal-to-noise ratio is worse than usual, and will remain so for several months. If current data reflects weaker activity that gets delayed due to the harsh weather, then we can also expect to see stronger catch-up data in coming months that would overstate the true level of demand. Other things being equal it will be well into spring, and hopefully warmer weather of May or June, before I would expect to see more accurate data on the economy.
So far, most equity market participants appear to be looking through the more volatile data, as well as policymakers such as the U.S. Fed who are maintaining the course on tapering despite the weak numbers. But I would like to highlight one very interesting chart, which I have borrowed from Torsten Slok at Deutsche Bank:
The chart shows that the consensus forecast for the level of U.S. economic growth and inflation in late-2014 has not changed as a result of the current weak data. In other words, economists are looking at the weak numbers as a temporary weather effect that has not changed their outlook on the U.S. economy to grow at a near 3% pace for the year and inflation to remain below 2%. The bond market on the other hand has seen the 10-year fall from 3% to 2.6%, clearly suggesting that bond yields are pricing in a weaker trajectory for the economy. Neither is correct! If the data sees a bounce from the weather induced weakness to some stronger than expected numbers, the bond market will sell off as rates are driven up and this gap will be corrected. Torsten also highlighted a similar period in 1996 when bad weather in January resulted in weak employment data followed by a significant rebound in February, the 10-year rallied by 100 basis points.
While I do not expect the same magnitude of a rate back-up, mother nature has set the stage to deliver some surprisingly strong catch-up numbers at some point in the upcoming two months. The February jobs numbers are released next Friday and while this atrocious weather has continued through February and hence will remain a headwind, we also have had three consecutive bad weather months and the effects are building from earlier months. If the economists are right (no laughing please), then whether we see a stronger bounce back in the data next week or in April is difficult to call. Either way the bond market is not priced for it.
Time for me to look into some cheap flights south...