Friday’s employment data were considered, by some estimates, to be the first true sign that employment is beginning to gain some traction. You may recall that the January data was believed to have been negatively impacted by inclement weather throughout much of the country. This was followed by a strong report in February, but much of the improvement was credited to a snap back in hiring (a make up effect) from the weather-influenced January data.
We believe that one economist summed it up well when he said:
“It’s not a blow-out number but all in all, it’s a good report.”
Most data components indicated improvements. Even government job cuts slowed from a prior -46,000 to -14,000. Professional and Business services (+78,000), Education and Health (45,000), Health and Social Assistance (45,000) and Leisure and Hospitality (37,000) led the sectors reporting gains. The Information sector came in at -4,000 and Transportation and Warehouse did not add any jobs. Manufacturing added 17,000 jobs. The forecast called for a gain of 30,000 new manufacturing jobs.
The so-called household survey reported a drop in the unemployment rate from 8.9% to 8.8%, even as the labor force increased by 160,000. However, the labor force participation rate remained unchanged at 64.2%. This is still below participation rate of 64.9% from years ago.
How can the labor force expand, but the participation rate increase? This is the result of an expanding U.S. population. It is generally agreed that the U.S. economy needs to add approximately 200,000 new jobs each month just to keep pace with the expanding population.
Not all of the numbers were good. Average Hourly Earnings were unchanged on a month-over-month basis and remained unchanged at a pace of +1.7% on a year-over-year basis. Therein lies the problem. Wages are not keeping pace with commodities prices. Consumers, especially middle-income and lower-income consumers, are being squeezed and must make difficult decisions between discretionary spending and heating their homes, fueling their car, putting enough food on the table or taking vacations, buying new appliances, or improving their homes.
Many businesses are also being squeezed. The Average Hourly Earnings data and the Average Weekly Hours data indicate that business spending on labor has not kept pace with corporate profits. Many businesses continue to find it difficult to pass along price increases to consumers as consumers may put off purchases rather than pay higher prices. To compensate for a lack of pricing power, companies continue to squeeze workers by trying to get more production from them and not offering much in the way of pay increases. Unless wage growth takes hold, higher commodities prices could be a drag on consumption. Even the Fed (and individual Fed officials) have lowered their growth forecasts.
Speaking of Fed officials, Minneapolis Fed president Narayana Kocherlakota stated in an interview that the Fed may need to raise short-term interest rates by year-end if underlying inflation rises. Inflation hawks and bond bears (who are usually equity bulls) ran with this story and began predicting an interest rate blow-out to anyone who would listen.
Mr. Kocherlakota believes that higher commodities prices may bleed into core inflation and require the Fed to raise rates. He uses the oft-cited Taylor Rule (which we have mentioned previously) to support his case for higher policy rates. Mr. Kocherlakota believes that inflationary pressures could result in a 75 basis point Fed Funds rate increase according to the Taylor Rule. He makes no mention of whether or not the 75 basis point increase would follow, precede or accompany a selling of U.S. treasury securities holdings accumulated between two rounds of quantitative easing.
According the Taylor Rule, an effectively negative Fed Funds rate was required to boost price pressures (and economic growth) prior to the Feds launch of two rounds of quantitative easing. A 75 basis point increase of the Fed Funs rate may only get the effective Fed Funds rate back to 0.00% or so if QE holdings remain on the Fed’s balance sheet.
We do not dispute that the Fed will change its bias to one of less accommodative Fed policies, but how it may begin to tighten remains unclear. The Fed could remove much stimulus by selling its U.S. treasury holdings without raising the Fed Funds rate. Simply not purchasing additional U.S. treasuries would result in effective tightening of monetary policy. Whether the Fed chooses to first raise rates or reduce the size of its balance sheet remains a question, but it is likely that the first move the Fed will make is to cease QE2 purchases in June.
Although they do not get the media attention given to the inflation hawks, there are a number of Fed officials who do not believe that QE2 purchases will be curtailed. Cleveland Fed president Sandra Pianalto said yesterday that “several important factors will keep inflation in check" and that among them, are "the continuing slow growth in wages, which helps determine the cost of producing goods and services and, in turn, the prices set by firms" and "retailers' reluctance to raise prices in the face of strong competition and soft business conditions."
This morning, New York Fed president William Dudley said in a speech in San Juan, Puerto Rico that he currently does not see a reason for reversing Fed policy in what remains a “still tenuous” recovery. He also termed the recovery as being “far from the mark” of the Fed’s goals of full employment and price stability. It is believed that Mr. Dudley’s view of the economy and Fed policy is similar to that of Fed Chairman Ben Bernanke. Also, the New York Fed president is usually the most influential of the presidents of the regional Fed banks.
Mr. Dudley went on to state:
“We must not be overly optimistic about the growth outlook. A stronger recovery with more rapid progress toward our dual mandate objectives is what we have been seeking. This is welcome and not a reason to reverse course.”
We would like to be clear that there is little contention on the street that the Fed will begin removing stimulus. However, how, when and to what degree the Fed removes stimulus is the subject of much disagreement. Based on recent comments from Fed chairman Bernanke and New York Fed president Dudley, the first step in removing Fed stimulus is likely to be the follow through on QE2 in June. Following that, it is likely the Fed will analyze economic data and gauge the markets’ reaction to both the economic data and the ending of QE2. If the recovery looks like it is gaining more traction and / or core inflation begins to spike, the Fed could raise the Fed Funds rate, begin reducing the size of its balance sheet or a combination of both.
Judging by the pace of the recovery, the population-replacement-like pace of job growth, a lack of wage growth and the lack of business pricing power that has been observed thus far, it is probably unlikely that we will see a spike in shot-term interest rates. Using Mr. Kocherlakota's favored Taylor rule as a guide and considering the unprecedented stimulus it has required just to get the economy to the current pace of recovery, it might turn out that not much tightening will be necessary to reign in inflation end keep growth under control. We doubt that many Fed officials are fearful of an overheating economy.
Following this morning’s economic data prices of long-dated treasuries are little changed. The price of the benchmark 10-year U.S. treasury note is up 3/32s to yield 3.46%. The price of the 30-year U.S. government bond is up 4/32s to yield 4.50%.
There is a possible phenomenon which some investors may have failed to consider, that being the possibility that the removal of Fed stimulus is considered by market participants to be anti-inflationary resulting moderating the rise of long-term interest rates. You might recall that following the launch of QE2 last November, long-term treasury yields began to rise due to fears that the latest round of Fed stimulus would prove to be inflationary. The reverse may be true when QE is halted and, eventually, removed.
When the Fed raises the Fed Funds rate, the response from fixed income market participants (at some point during the tightening cycle) is that the Fed has tightened more than enough to combat inflation and begins to move capital farther out on the yield curve. Since QE is akin to lowering the Fed Funds rate, the removal of QE2 could have the same effect as raising the Fed fund rate.
Bloomberg has posted a revised interest rate forecast as per their survey of fixed income market participants. The current year-end 2011 forecasts are as follows:
Interest Rate Forecasts Q4 2011 Q1 2012 Q2 2012
30-year: 4.95% 5.14% 5.23%
10-year: 3.89% 4.10% 4.21%
2-year: 1.33% 1.68% 1.95%
3-month USD LIBOR 0.62% 0.89% 1.27%
Fed Funds Target Rate .25% 0.50% 1.00%
As you can see, the street does not believe that interest rates are poised to take off, but rather rise gradually. If these forecasts come close to fruition, a laddered portfolio with a duration on the belly of the curve 5 to 7 years out (with maturities out top 10 years) may prove to be advantageous. Step-ups could provide some cushion against modestly higher long-term rates, but floaters adjusting off of short-term benchmarks, such as LIBOR, may disappoint investors.
The truth of the matter is that the recovery sucks. This is due to two factors.
1) The economy is not fundamentally capable of growth rates seen during recoveries of the past two decades. A perfect storm of evermore accommodative Fed policies and ever easier lending standards combined to fuel economic growth by promoting borrowing.
2) Consumers will have to continue to deleverage.
The economy will recover slowly and peak at what will be a disappointing level for many Americans spoiled by getting what they want when the want it.
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