Private Eyes

Disappointing jobs numbers today. Not only did the headline Nonfarm Payrolls number disappoint, but the more important (for an economic recovery) Private Payrolls data missed big time. The street consensus called for a 180,000 job increase in private payrolls. The economy added only 41,000 jobs. Most economists believe that the economy needs to add at least 100,000 jobs just to keep up with new workers entering the labor force. Since most of the 390,000 new government jobs were temporary census-related jobs, this is bad news for those looking for gainful full-time employment. The unemployment rate did drop, but the likely cause for that were more displaced workers answering the so-called household survey that they were not seeking employment. A quirk of the household survey is that if an unemployed workers answers the survey that they are not seeking employment at that time, they are not considered to be unemployed. Average Weekly Hours increased. There are two ways that the data can become more positive. The first and best for the economy is for more workers to be added to company payrolls. The other is for existing workers to be asked to work longer hours. It appears that the latter is true at this time.

The fun didn't stop in the morning. After reacting to the numbers (stocks and bond yields both trending lower), things deteriorated in the afternoon. The Dow Jones Industrial Average plummeted during the final hour of the trading session to finish down 324 points and stands at 9931. The price of the benchmark 10-year note finished up 1-13/32s to yield 3.20%.

Some more optimistic pundits have blamed overreaction to problems in Europe or short selling for the markets' correction. I have another theory. I believe that reality is setting in. Market participants are coming to grips with that fact that the global economy is not going to rebound as it had during the past two decades. We have kicked the stimulus can down the road.

In the past, whenever the economy would slow too much for the tastes of politicians, consumers and market participants, governments would stimulate the economy by lowering interest rates. This would promote borrowing, both new debt and the refinancing of existing debt. Newly-found credit would encourage consumer spending. There was another dangerous consequence. By lowering interest rates investors were forced into ever riskier assets to maintain income and rates of return. This led to the expansion of subprime lending. In the past only very aggressive investors would purchase securities backed by subprime mortgages and would demand very high yields to do so. However with interest rates low and continually dropping, more moderate and even conservative investors began purchasing such mortgage-backed securities and they didn't need very high yields to pique their interests.

The demand for yield attracted buyers to MBS. The increased demand pushed MBS yields lower and thereby pushed mortgage rates lower. It also permitted mortgage lenders to lower their lending standards in an attempt to create more MBS. Profits among lenders soared. The ratings agencies, seeing the historical performance of such loans, began giving bonds with ever lower quality mortgages AAA credit ratings. Quantitative modelers at the banks looked at the same data and came to similar conclusions. What few realized (or was willing to acknowledge) was that old default data no longer applied. Why did it historical data no longer apply? First: There were borrowers receiving loans who previously would not qualify. Secondly: In the past, if need be, borrowers could easily refinance their debt if they became over extended as rates trended lower and home prices rose. In cases of extreme distress, home owners could simply sell their homes at higher prices and move on. Modelers apparently did not take these facts into account.

Things are different today. Rates cannot be made lower. Lending standards are once again responsible. Home prices have corrected or are still correcting. The stimulus pumped in to the economy by the government has gotten us off of the bottom and has averted an economic catastrophe, but it cannot push the economy back to previous levels, levels which were not fundamentally sustainable. This is Bill Gross's "new normal".

Mr. Gross of PIMCO fame has been very vocal stating the economy is at a "new normal." By this he means that there is nothing to drive the economy higher. There is no new technology, transportation innovation or stimuli to drive job creation. Job creation and / or wage growth is necessary to increase consumer wealth to accelerate spending and driver stronger growth. The economy was able to expand due to cheap and plentiful credit. That could only go so far and has run its course. The evidence of this is in yesterday's Nonfarm Payrolls report. The private sector added a pitiful 41,000 jobs and while once should not become overly pessimistic due to one bad jobs report (or overly optimistic when there is a good jobs report), there is now nearly unanimous opinion in the markets that the recovery will be much slower than what was hoped and inflation is not a problem.

Inflation and higher rates have been on the minds of investors who tend to have a myopic view of the U.S. debt situation. They believe that because the U.S. has infused mega stimulus and has issued huge amounts of debt interest rates in the U.S. must rise. That would be true if the economic troubles were isolated and unique to the United States. However, this is a global problem. Currently the U.S. is the least ugly girl at the dance or, as Bill Gross termed it yesterday: "The U.S. is the least dirty shirt." Economics is like bear hunting with your friends. When the bear charges you don't need to be faster than the bear, just faster than your friends. Currently the U.S. is faster than its friends. We can only hope that economic policy keeps us out in front. Although poor policy decisions in Europe and Asia have been helping to keep us out in front, pending legislation promised to cause the U.S. to stumble. Still I agree with Mr. Gross. The U.S. will be the best of a bad bunch and interest rates will rise only modestly in the coming years, topping out at historically low peaks.

Try enjoy the weekend. Monday is only two days away.