I don’t believe the jobs report today is indicative of an improving US economy. I believe it is a one-off that is so strong that it will be difficult for the Fed to overlook it. And this makes the likelihood of rate hikes that much greater, even while past tightening is working its way through the system. A recession in 2016 cannot be ruled out.
I am going to make this post short. My view on the current state of the US economy has not changed. But my view on the chances of a rate hike have changed and I believe this is negative for the US economy. Let me remind you how I started and finished my synopsis regarding the Fed and the faltering US economy last month:
“According to Jon Hilsenrath at the Wall Street Journal, ECB and PBOC easing aren’t obstacles to a Fed rate hike before year-end. Yet, the Wall Street Journal is running a headline as its top story showing that, “U.S. Companies Warn of Slowing Economy”. Given monetary policy acts with a lag, we are now in a dangerous period for the US economy.
[…]
“What I see then is a “currency war”, with the US losing that war as it maintains a hawkish stance even as the ECB loosens further. This will put more pressure on emerging markets, particularly China and the need for China to devalue will soon re-assert itself as a driving macro issue given the Renminbi’s peg to the US dollar and the decline in Chinese growth rates.
“In my mind, these are now dangerous times, with the Fed potentially misreading the macro tea leaves. If the Fed thinks that economic and financial conditions have eased, they are reading the situation wrong. And this incorrect read could lead to more tightening even as the effects of past tightening work their way through the economic system.”
Now, let’s remember that non-farm payrolls over the last three months grew by an average of 187,000, which is not exactly spectacular. But this past month’s number was off the charts good and all of the factors line up for a hike:
- The US economy added 271,000 jobs, the strongest pace this year, well outpacing consensus of 182,000
- The unemployment rate is down to a seven-year low of 5.0%
- Wage growth is now up to 2.5% year-on-year because average hourly earnings were up 0.4% month-on-month, the 2nd straight month of great numbers
Combine these numbers with the ISM Non-Manufacturing number at a relatively healthy 59.1% in October and you have an economy that, outside of the manufacturing sector, looks healthy and poised to go higher.
Before this piece of data, the odds of a December hike were already 58%. Now they are 72%. The mantra from hawks now that wage growth has perked up is that the Fed is behind the curve. This is particularly important as Janet Yellen has been looking at labor markets as the key to being able to get off zero at the Fed. The most important takeaway here has to be about the pace of hikes though because a Fed that is behind the curve is one that isn’t going to deliver one and be done. It is going to set out a train of hikes going forward.
Now, domestically this is bad news for bonds as the 2-year is at the highest level in 5 years. But the big news here is about currency moves and the carry trade. The euro fell to 1.073 to the US dollar on this news. With the ECB talking more QE, parity is a stone’s throw away. Sterling has lost 4 big figures in the last 48 hrs due to the dichotomy between the Fed’s policy outlook and the Bank of England’s. The EU downgraded growth forecasts for both the Eurozone and the UK just this week. And the dollar in general is crushing it.
So, we have the stage set for serious policy divergence, with China set to be dragged in tow with the Fed. A strong dollar will put a heavy burden on the Chinese economy that, despite incipient signs of a modest resurgence in Chinese growth, will put downward pressure on the Yuan. I believe this will entrench deflationary pressures in emerging markets that will also come from the commodity side of things given commodities are priced in dollars.
Narrowly-speaking, a slight uptick in US yields is bullish for private sector net interest income, and contrary to standard economics, may actually bolster the US economy through this channel. GDP growth is still in the 2%ish range as the Atlanta Fed’s Q4 GDPNow forecast is tracking 2.3% at the moment.
But hikes will be toxic for the riskiest of risk assets, which are dependent on easy money from private portfolio preference shifts induced by Fed policy. Moreover, the impact on emerging markets is likely to be negative. With global U.S. companies already warning of slowing and US S&P500 earnings down for two quarters on the trot, the stage is now set for further slowing on this front. There is the potential for this confluence of events to create recession.
I don’t envy the Fed because it is in a tough position given the dominance of monetary policy. But, at the same time, I believe the Fed is misreading where we are in the economic cycle. The best time for hikes was probably 2014, right after the Fed tapered asset purchases (not that the Fed should have lowered rates to zero or provided monetary offset when fiscal policy turned tight. But those are separate issues). The important thing is that, right now, I believe the US economy is slowing just as the Fed is signalling rate hikes. Caveat Emptor.