Today's employment report will be met with relief at the Federal Reserve. The report was generally strong, but more importantly, it showed that last month's weak report was likely an aberration. If you had any doubt the Fed would be hiking in June, doubt no more. Here are some quick thoughts on the details of the report.
Weakness? What weakness?
I wrote last month that the relatively poor increase of 98,000 jobs was probably an anomaly. No other employment indicator had shown any weakness. Plus, we had seen two straight above-trend payroll reports prior to March, and thus to see a below-trend report subsequently shouldn't be too surprising. Lo and behold, here we are with another above-trend report.
It is fair to ask, then, what's the real trend here? The six-month moving average for Non-Farm Payrolls is 176,000. The average for ADP over the same period is 229,000, but the 12-month moving average is 195,000. The six-month average for the Household Survey is 209,000. There are some structural differences among the surveys, but I think for all three we can say right around 200,000 or slightly lower is probably the right trend level.
Unemployment rate making lower lows
Last month economists were surprised by the unemployment rate dropping by 0.2% to 4.5%. So naturally, they thought it would correct back to 4.6%. But instead we dropped again to 4.4%. Unemployment hasn't been this low since 2007 and hasn't been lower than this since 2001.
It is interesting to note why it dropped so much. Over the last three months the Household Survey indicates more than 1 million new jobs were added with only mild increases in the labor force. So, unemployment is falling for positive reasons. On top of that, indications are that more workers who had been only working part-time are finding full-time work. In the last two months alone, the number of "Part-Time for Economic Reasons" job holders fell by nearly 600,000 people. These are folks who are working part-time but want to work full-time. We can't say exactly what happened to those workers, but given that total employment has grown rapidly, we can assume that these people overwhelmingly found full-time work.
Put together, it is a pretty powerful story. Something like 1 million people have found work, and another 600,000 people are working significantly more hours.
If you are the Fed, this is good and bad news. Your models tell you that such a robust labor market should lead to higher wages, which in turn should cause inflation to accelerate. The models will then suggest that you are going to have to hike rates a bit faster than you would have otherwise. However...
Wage growth didn't accelerate
I can hear Janney Montgomery's Guy LeBas and other Phillips Curve skeptics saying "I told you so" from all the way here in Baltimore. Year-over-year, the increase in average hourly earnings actually decelerated slightly to 2.5%, mainly due to some downward revisions. In and of itself, 2.5% isn't a terrible number, but it isn't supposed to be decelerating with unemployment this low and job growth this strong.
The Fed's models assume there is a direct inverse relationship between unemployment and inflation, known as the Phillips Curve. As I said above, this concept definitely has its detractors, because historically it can be difficult to show empirically such a relationship. Since I don't need to be the one setting policy, though, I can think about it a little more simply.
All else being equal, if there is strong labor demand and shrinking labor supply, it stands to reason that wages will rise. This relationship doesn't need to cause inflation, but it certainly makes it easier to have inflation. Further, it makes sense that if we are at full employment it isn't likely that continued monetary stimulus will be helpful. So as an investor, I don't need to buy into the specific Phillips Curve concept to assume that this data is probably going to put upward pressure on interest rates.
That said, what do you do with the lack of wage acceleration this month? I don't think you worry about it too much. Yesterday, unit labor costs, a Fed favorite, came in at 3.0% on very weak productivity. Other surveys and anecdotal evidence have suggested wage pressures are building. Just because we didn't see it in the data this month specifically doesn't mean it isn't there.
What does this mean for trading?
I continue to think there is very little downside for interest rates or upside for bond prices near term. The market is still only pricing about 50% odds that the Fed hikes twice between now and year-end. Maybe this is because they are building in the chance that the Fed passes in December so they can announce a balance sheet adjustment. But for intermediate-term rates, that's not really here or there. Continued Fed hikes into 2018 are highly likely at this point. Betting on somewhat higher rates, especially in the 3-7 year part of the curve, is the way to go.
