Some initial thoughts on the US Jobs report, the Fed’s reaction function and tapering

Today’s commentary

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Summary: The U.S. Job Situation Summary was released this morning at 830EDT and the headline number of 169,000 jobs added to non-farm payrolls was just below consensus. Moreover, the unemployment rate dipped to 7.3%. Nonetheless, the reaction to the number was negative and for good reason. Below are my thoughts.

As I write this, the U.S. Treasury market is rallying and has staged a 12 basis point move down from a yield of about 3% to 2.88%. That is a big, big move and it gives you the sense that the market doesn’t like these numbers. Here’s why:

• I am big on momentum in second derivatives – the change in the change – as a harbinger in major shifts. And there are two negative data points that stick out here on that score. First, we are now getting downward revisions to data. In this report, the last two months’ non-farm payrolls were revised down an aggregate 74,000. Negative revisions are always a bad sign. And let’s remember then that just six months ago the 3-month moving average for NFP was +233,000. Now it is just +148,000. This means we have had a massive downward shift in the growth in jobs in just six months.
• In addition, the labor force participation trends continue to be negative here. For example, the employment to population ration declined yet again to a new secular low of 58.6% while the labor force participation rate is now also very low at 63.2%. This speaks to a secular decline in the labor force that has not translated into productivity growth. If you have lower participation rates and lower productivity growth, you get lower nominal GDP growth. Josepeh Bruselas of Bloomberg noted: “The combination of a reduced labor supply in addition to weak productivity growth implies a slower US growth trend that is below 2.5%”.

Here’s what I see as the dynamic. First, we have a deceleration in the jobs market’s improvement at the same time the Fed is looking to taper its large scale asset purchases. Second, the Fed wants to taper. It is looking for any excuse to do so in the wake of comments by Jeremy Stein about market participants reaching for yield. Third, the reach for yield continues in debt markets despite the huge selloff in emerging markets. High yield is doing very well with record issuance this year and tight spreads. Sober Look is calling this a bubble. Products like leveraged loan ETFs speak to extreme frothiness and appetite for risk as people reach for yield. Whether it is a bubble or not remains to be seen, the reality is that companies like Sprint are issuing post-crisis record large deals into this yield-starved market even as other high yield plays in emerging markets have dwindled due to increased risk. In fact, I would argue we are seeing a rotation into high yield out of EM for that reason.

But, the tapering talk has caused US mortgage rates to shoot up to an area near where I think that tapering won’t happen in September. So we have a bit of a recursive play here regarding the Fed’s reaction function. The Fed wants to taper and the bond market has sent yields higher for this very reason. Yet, the move higher has been far more powerful than the Fed wanted or than any of us imagined at the outset. US interest rate increases create demand destruction and are thus self-limiting due to recession and the Fed’s reaction function. The higher rates go, the less demand for credit we will see, especially in mortgages – and that’s what is driving the U.S. recovery. Britain take note.

All in all, I believe the rise in rates has damaged the U.S. recovery and has had a negative impact on the U.S. labor market. We are right about on the cusp of the Fed not tapering in September for this reason. The give back in rates today makes tapering more likely but if we move higher from here, we should question whether tapering is going to occur. 

One last thought: The US Dollar has fallen on this news and I think this is something we need to look at because the Yen plummeted 1.3% against the dollar to near 98 yen per USD on the back of this news. As I wrote in yesterday’s piece, I am bearish on Japan now despite the government’s recent upgrade in the assessment of the economy. I believe the coming consumption tax is going to damage growth and will lower inflation expectations. The Yen is already creeping up. If the Japanese economy weakens, because rates are at the zero lower bound, I would expect the Yen to strengthen further. Something to watch