The June non-farm payrolls report is being greeted with praise from all markets Friday. Stocks like it because it is strong enough to support consumer demand but not strong enough to push the Fed into hiking faster. Bonds like it because the lack of wage pressure will allow for steady long-term yields.
Here's my take on what this report tells us about where the Fed is going and what it means for markets.
What Was in This Report?
The headline job gain figure was slightly better than expectations (+213,000 vs. Bloomberg's survey of +195,000) and with upward revisions of +37,000 from prior months, that's a strong result. Here's where I give you my monthly reminder that the error term in the payroll estimate is quite high, so you should never get too excited about any one month no matter what the result is. However, a net beat of more than 50,000 is legit.
Many media reports will probably focus on the uptick in the unemployment rate from 3.8% to 4.0%. The deltas here were that the denominator (i.e., the labor force) grew by 601,000. They estimate that the population at large grew by 188,000, so on the net the 601,000 increase suggests a large number of people who were previously not looking for work now are.
Digging into the numbers, it looks like about 200,000 people went directly from out of the labor force to working, while about 200,000 people lost their job and haven't found something else yet, and then another 200,000 have decided to start searching for a job again after previously giving up.
Lastly, wages came in a bit weaker than expected. The month-over-month figures came in at +0.2% vs. +0.3% last month (survey was expecting +0.3% this month). That pushed the year-over-year number to +2.7%, lower than the +2.8% expected based on the Bloomberg survey.
Markets Like the Wage Miss
Both stocks and bonds rallied a bit right after this release due mainly to the mild wage miss. The fed funds futures market is pricing about 3% lower odds of a two additional rate hikes this year. All this makes sense if you figure that the Fed would feel forced into making that second hike by particularly strong wage growth.
On the margins, I understand why markets are rallying, but I actually think this report makes the odds of two additional hikes this year higher, not lower.
The Fed Isn't Really Data Dependent Anymore
Fed Chair Jerome Powell and company are in a new phase of monetary policy, but the market doesn't quite realize it yet. This phase will be much less reactionary to incoming data and more about the general thrust of the economy.
Consider what's happened so far this year. The Core PCE price index (the Fed's favored inflation measure) ended 2017 at just 1.5%, and was as low as 1.3% during the year. Running that far below their inflation target, they faced pressure from many corners to slow the pace of rate hikes. Janet Yellen (and later Powell) assured us that inflation was being dragged down by transitory factors and that rate hikes at about the same pace were still the correct course of action.
Now with the most recent year-over-year Core PCE report printing at 2.0% despite a steady set of rate hikes, the Fed sure looks vindicated. Had they paused their tightening in mid-2017 and waited until recently to restart hikes, they would seem behind the curve. As it is, they look like they've masterfully navigated some tricky waters.
Moreover, I think they like how things are developing in financial markets (with the possible exception of the flat yield curve). In 2017, markets seemed ebullient. Stock P/Es were high, credit spreads were extremely tight, etc. S&P 500 forward P/Es are now down almost three points from recent highs, investment-grade corporate bond spreads are about 40 basis points wide of the recent tights, junk bonds about 50 wider, etc.
The combination of rate hikes and quantitative tightening have dented sentiment enough that markets aren't effusive, but not so much that anyone is panicked. That is exactly the kind of middle-ground outcome the Fed wants.
From the Fed's perspective, what's not to love? Unemployment is low, inflation is at their target, and financial markets look stable. Given all this, why would they change course now?
Follow the Plan
The Summary of Economic Projections, which includes the Fed's collective economic forecasts as well as the so-called "dot plot" is telling in this case. In March, the Fed's own projections showed they expected Core PCE to rebound to 1.9% (from 1.5% at the time) by the end of 2018. Based on that forecast, they were evenly split between three and four total hikes in 2018. Projecting out further, they had a pace of hiking roughly one time per quarter, with maybe a skip here and there, until mid-2020.
As long as the Fed's general forecast seems to be coming to fruition, they are going to keep hiking at this pace. That means that even fairly large deviations will be tolerated as long as the broad thrust seems to be the same. That was their attitude as Core PCE was slowing in 2017 and it worked out perfectly. Expect them to be emboldened by this to stay on course.
So What Are the Trades?
1. Odds of a December rate hike should be more like 80%, not 50%. As the market comes around to that view, short-term rates will rise and the yield curve will keep flattening. You can either buy iPath U.S. Treasury Flattener ETN (FLAT) or go long iShares 20+ Year Treasury Bond ETF (TLT) and short iShares 3-7 Year Treasury Bond ETF (IEI) . Alternatively, you can go long iPath U.S. Treasury 5-Year Bear ETN (DFVS) , which is a bear 5-year ETN.
2. The market's intermediate-term rate path is non-sensical. Right now, the market has priced in three more rate hikes, basically one more this year and two in 2019. Then it has rates steady from then until kingdom come. There is a zero percent chance this happens. If the economy continues to be strong, the Fed will keep hiking. Their dots suggest rates end 2020 at 3.5% vs. slightly under 3.0% currently priced in. Even at 2.71%, I think the 5-year Treasury is overvalued. If you don't like my pair trade above, I like the short side outright as well.
3. Dollar has room to run. I also think the recent U.S. dollar rally has plenty of room to run as we price in the December rate hike. I'm long WisdomTree Bloomberg U.S. Dollar Bullish ETF (USDU) right now. It's down a good bit Friday, so it isn't a bad entry.
