Why the July Jobs Report Could Be a Game Changer

Friday's huge U.S. non-farm payrolls beat may be a game changer. It almost certainly cements QE tapering for fourth-quarter 2021. It may also be a moment that gets Treasury market momentum going the other way. Unfortunately it wasn't all good news, though. Here are my thoughts on the report as well as where markets are headed next. Job Gains Strong and Widespread The headline non-farm payrolls gain came in at +943,000, which was about 100,000 better than expected and came on top of 119,000 in upward revisions to prior months. The beat was mostly in public education hiring, which surged by over 200,000 in July alone. However, don't let that fool you. There were outsized job gains all around. In the hard-hit hospitality sectors, payrolls climbed by 380,000. This puts those sectors on pace to fully recover the pandemic job losses before year-end. Perhaps more notable is strong hiring outside of the crisis sectors. The sum of all sectors excluding government, restaurants, hotels and leisure gained 322,000. To put that in context, that's a 0.29% gain in one month. If we extrapolated that out to the whole economy, it's the equivalent of gaining 430,000 jobs in a single month. That's good enough for the fifth best month between 1990 and 2019. In other words, even the non-crisis sectors are seeing blowout job gains. Employer demand for workers is strong across the economy. Effect of Delta Variant Still Unknown Unfortunately, we can't draw any conclusion about whether the Delta variant will effect economic activity. The survey period for this report was July 12-16, probably too early for any impact to be measured. Personally, I'm not that worried about overall economic impact being large or lasting, but it's worth noting that current data doesn't tell us anything useful in that regard. 'Substantial Progress' Probably Now Met The Fed has been telling us they need to see substantial progress on employment before announcing any tapering of QE purchases. I think with this report that progress goal has been reached. There was some speculation that Fed Chair Jerome Powell could use his Jackson Hole speech later this month to overtly telegraph QE tapering. I think September is a more likely timetable, but this strong report at least puts the Jackson Hole possibility in play. Labor Supply Remains Concerning I've been sounding alarm bells about labor supply for months now, and this report is another concerning piece of evidence on that front. While the labor force did grow by about 260,000 this month, it is still far behind where I'd expect it to be. Overall Labor Force Participation (LFP) has been stuck between 61.4% and 61.7% for over a year now, far below the 2019 average of 63.1%. It is true that historically LFP has recovered slowly after recessions, but in prior periods this has been because labor demand was weak and people give up looking for work. Today labor demand is white hot, so whoever is not looking for work is choosing to do so. Some of this may improve as enhanced unemployment benefits expire next month. However, in many states that expiration has already happened, and there is mixed evidence that it has resulted in people re-engaging with the labor force. If the expiring benefits don't engender faster labor force growth, it is unclear what other near-term catalyst exists. What this means is that the extremely tight labor market conditions we see now are likely to persist. This has two major consequences. First, it means that strong wage pressure isn't going to abate. In July, Average Hourly Earnings jumped by 0.4% and they have risen at a 3.65% annualized pace so far this year. That compares with just 2.9% in the 2016-2019 period. Note that this 3.65% pace probably understates wage growth, since an outsized percentage of job gains have come in lower wage sectors, which tends to make the delta look smaller than it really is. This wage pressure is the key ingredient for persistent inflation, so if the labor market is already at a tight point, it tells us that inflation will remain elevated even after the pandemic-induced price shocks fade. In other words, headline inflation prints will no doubt slow from the 5% area they are now, but will probably still remain above 2%. As Fed Vice Chair Richard Clarida told us on Wednesday, that will be enough to elicit rate hikes as soon as 2023. The second major consequence is that companies are going to struggle to increase output. At its core, economic growth requires either more people employed making stuff or the people we already have to get more productive at making stuff. With labor in such tight supply, the first of those is going to be challenging, and productivity enhancing investments usually take time. If labor supply can't start growing soon, it indicates we're later cycle than we might have previously assumed. Curve to Flatten Either Way The yield curve steepened right after this report, which means that shorter-term bond yields are rising by less than longer-term bonds are. I don't think this is the right reaction and therefore wouldn't expect it to last. This jobs report definitely gets us closer to QE tapering, but also probably gets us closer to rate hikes. Rate-hiking cycles always result in a flatter curve. Moreover, if we really are running out of workers and therefore are late in this cycle that limits how high long-term bonds can go, further supporting a curve flattener. Lastly, the typical reason why the curve would steepen while rates are rising is a build up of long-term inflation expectations. Good chance that's already peaked, with any additional inflation pressure merely resulting in more rate hikes. Again, that's typically a time when the yield curve flattens. I say this not only to highlight how I'm positioned but also a warning to those holding bonds in the 0-5 year area. It could be that that's the part of the curve that sees the most pain.

Why the July Jobs Report Could Be a Game Changer

What you need to know about the blowout report and where markets are likely headed next.

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