It is another payroll Friday, and once again we have the same conundrum. Job gains were especially strong, surging 313,000 in February with another 54,000 of upward revisions to January and December. And yet wage growth remains tepid, rising just 2.6% year-over-year, missing both expectations and downshifting from last month's read. What will the Fed think of this? And what trade ideas might work here? Here are my thoughts.
Who do you believe?
Let's start with wages and work our way through this report. This is obviously what the market is reacting to, as stocks surged and bonds are bear steepening (i.e., longer bonds rising in yield by more than shorter bonds, which tends to mean this isn't about near-term Fed hikes). Anyone who is following company earnings reports is hearing a consistent theme: labor costs are going up. Dollar Tree (DLTR) just the other day is a great example, warning that a combination of increased wage and transportation costs would hit EPS to the tune of $0.22. With their multiple, that alone is worth about a 4% decline in the stock's price. I pick on them because it is a company my firm owns that just reported, but we're hearing it all over.
Yet it isn't showing up in the macro statistics. Why not? I'm convinced it is due to the mix of job gains we're seeing. In other words, new entrants into the labor force are mostly taking lower wage jobs. So the average wage of everyone in the job pool may be growing pretty slowly, but only because the new members of the pool are starting with below average wages. If we did the equivalent of a same-store metric, i.e., looked only at people in the job pool for the last two years and measured their wage growth, my bet is that we'd see more obvious acceleration.
I'm generally more in favor of hard data over anecdotal evidence. But when just about every company, especially those which employ lower skill workers, are telling investors that labor is tight and wages are going up, that has to mean something. In addition, the anecdotal evidence fits what basic economic theory tells us should be true, whereas the macro data is pointing the wrong direction. Maybe my theory above isn't the reason (or isn't the only reason) why Average Hourly Earnings isn't capturing rising wages, but whatever the reason, I'm convinced wages are rising.
So will the Fed accelerate?
For the moment, the strength in the labor market is probably bringing the doves back into the fold. Just this week, Fed Governor Lael Brainard, who here to date had been firmly in the dovish camp, gave a speech saying that we are seeing "headwinds shift to tailwinds" and this could result in a faster pace for hikes. It doesn't seem she was endorsing four hikes in 2018 just yet, but most commentators figured she was one of the two hike dots previously.
Trading in December fed funds futures confirms this view. They aren't much changed today, pricing an expected rate of 2.11% at year-end basically unchanged today.
So does a 300,000 job gain mean nothing?
Equities want to see job gains all else being equal, but don't want the Fed to hike too fast. Hence why stocks are surging on this report. Big job gains means the economy is healthy, general demand for goods will be strong, etc., while lack of wage acceleration will keep the Fed from taking the punch bowl away.
This may be simplistic. Both Brainard and Fed Chair Jay Powell have recently introduced a new element to the Fed's reaction function that isn't getting as much attention as it should. Brainard, in her March 6 speech, suggested that inflation wasn't the only risk to the economy running hot:
"If the unemployment rate continues to decline on the current trajectory, it could fall to levels that have been rarely seen over the past five decades. Historically, such episodes have tended to see elevated risks of imbalances, whether in the form of high inflation in earlier decades or of financial imbalances in recent decades." (emphasis mine)
Powell mentioned financial stability in his congressional testimony recently, specifically warning they needed to strike a balance between "avoiding an overheated economy and bringing PCE price inflation to 2%". In both cases, they are saying that there are risks to the economy that aren't just inflation. Which in turn means that the Fed could accelerate hikes even if inflation doesn't seem to be a clear and present danger.
This has become a bigger risk to risk assets than rates
If the Fed does accelerate without inflation rising, it will hurt short-term bonds but not long-term bonds. In fact, I'd be looking to get even longer long-term bonds if I became more certain that the Fed were accelerating. Why? Because tighter monetary policy without an acceleration of growth/inflation is good for long-term bonds. It is bad for short-term bonds.
Meanwhile, if the Fed is worried about financial market conditions and hiking to address it, that's definitely bad for risk assets. P/E ratios would have to come down and credit spreads would have to widen.
Here are some trades I've done recently. First, I've had a long bond and flattener trade on for a while. It hasn't worked over the last 6 weeks or so, but the flattener part has been a big winner over the prior several months. Second, I've reduced high-yield. Not super aggressively, but right now the bias is to sell bonds that get tight rather than ride out the yield.
I'm looking at adding some more beta to my rates idea. One more aggressive way to play it is with mortgage REITs, such as Annaly Mortgage (NLY) . The stock is down 16% since December 15 and generally drops when rates rise and vice versa. However it is currently trading at nearly $10, which has been a serious support point in the last two big selloffs. In my years trading this stock, the real danger zones have been when they are cutting their dividend (see the rout in 2013), but they've already cut to $0.30 and by my estimation, that should be stable for a while anyway. I think this is worth nibbling if the price gets down to $10. The yield at that point would be just about 12% and while there's still downside, and I'll make the position small enough such that I could add if it kept trading down, this isn't a bad entry.