How to Look at Friday's Jobs Report

 | Jun 01, 2017 | 6:00 AM EDT
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This commentary originally appeared on Real Money Pro on May 31. Click here to learn about this dynamic market information service for active traders.

With the employment report for May looming this Friday, I thought it would be a good time to step back and consider the state of the labor market, what it says about our ability to keep growing the economy and consequences for interest rates.

Can we keep growing jobs even if we've reached full employment?

You have probably read that we should expect job growth to slow, now that we've reached full employment. Although this makes perfect sense, this hasn't actually been true historically. Measuring employment gains beyond "full" employment is a little challenging, since there isn't a definitive definition of full employment. Regardless, the data shows that the U.S. economy keeps gaining jobs persistently, right up until a recession is imminent.

To illustrate this point, we looked at every period from 1964 until today when unemployment fell to 5.0% or lower. In the chart below, each line starts in the month when the economy first hit 5.0% (while generally falling). We then measure job gains from that point until the economy falls into a recession. We used nonfarm payroll gains as a percentage of the total labor force as our measure of job gains. This allows us to look at the data consistently over different time periods. We also did this on a rolling six-month basis to smooth out random fluctuations.

Source: Bureau of Labor Statistics, National Bureau of Economic Research

In each case (other than the red line representing today), the line ends when a recession hits, so as you get to the end of each line, consider that the economy is slowing considerably. We can see that the slope of the lines moves around a bit. In the 1964-1969 period, the pace of job gains fell from around +0.4% to +0.1% before recovering. For context, in today's environment that would equate to a range of +160,000 to +640,000 jobs. However, we can see that all of the lines are comfortably above zero until a recession is imminent. In fact, all the lines show pretty sudden downward shifts around six-12 months before the recession comes.

Notice the red line, representing the current period. Already, job gains are pretty low compared with other time periods. That probably has to do with our relatively slow growth in the labor force and generally mediocre GDP growth. But regardless, it doesn't leave us that much above zero. So, the answer to the above question is a definitive yes. Not only can we keep growing jobs, it appears we need to keep growing jobs at about this pace.

We are either winning or we are losing

Another way to consider this question is to look at job gains leading up to a recession. The next chart shows job gains (measured the same way as above) in the 36 months prior to each official recession since 1969. (Note this adds some recessions not in the prior chart, since in some periods we never got to 5% unemployment).

Source: Bureau of Labor Statistics, National Bureau of Economic Research

Here we see something interesting starting to develop. First, we see a similar pattern as the first chart: the job gains seem to be solidly positive until the recession is imminent. But here we can be a bit more specific. It looks like job growth doesn't fall below around 0.1% on a sustained basis without falling into a recession. In this chart, we see each time we cross definitively through that 0.1% line, we're going into recession.

Does this hold up if we look through all time periods?

Yes, it does. We get some head fakes where job growth falls and then rebounds. But a holistic look at the history of job creation suggests that we are either growing at 0.1% of higher (which today is about +160,000) or we fall below zero and typically head into recession.

Source: Bureau of Labor Statistics, National Bureau of Economic Research

Why would this be?

It isn't immediately obvious why the economy can't just hover at the same level of total employment, especially when people think about the concept of "full employment". It makes sense that if we are at "full" employment, there aren't many workers just sitting around looking for work. If all the hiring involved convincing people to move from one firm to another, net hiring would be zero. This seems logically possible, if not likely, once we are at full employment.

It is logical, but it isn't what seems to actually happen. What seems to actually happen is more like the concept of stall speed: the economy has to grow at a certain pace in order to maintain business confidence. If things slow such that companies aren't hiring or investing in new capital equipment, then GDP growth stalls, aggregate demand slacks, and pretty soon people are getting laid off.

So, are you saying a recession is imminent?

Not at all. The economy seems to actually be picking up some steam. This whole column isn't to predict a recession, but rather to give some context as to how we should be looking at future jobs reports.

First, we seem to be right on the historic stall speed level of +0.1% job gains, or roughly +160,000 jobs. I don't want to over-emphasize this exact level, but if the pace of job gains slows materially, say to +120,000 or so, I wouldn't view that as benign at all.

Second, consider the most recent GDP report, showing growth at 1.2% for the first quarter and 2.0% year-over-year. If we are already at full employment, it isn't likely we can grow much faster. We don't have many instances of real GDP growth accelerating while employment growth slows. Yet there probably isn't much room for employment growth to accelerate. The labor force has grown 106,000/month over the last year. We can certainly grow at around the pace of +160,000-200,000 for a while before exhausting the supply of sidelined workers, but we can't realistically grow a lot faster than that for very long.

What does this mean for the Fed and interest rates?

If the economy can't reasonably grow much faster than this, then it isn't obvious why longer-term interest rates should be substantially higher. I think the 10-year Treasury is a bit too low, given the current Fed outlook, but I doubt it can trade any higher than 2.50%-2.75% without either substantially more inflation or until we've passed through the next recession.

I am currently underweight duration (meaning, I'm betting interest rates rise) but only mildly so, and I view it as a short-term trade. Much more importantly, I'm positioning the credit risky part of my portfolio like we are very late cycle. I don't pretend to know when the next recession is coming, but I will bet that growth has already peaked.



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