Friday, February 6, 2015

On The Cusp Of Raising Rates?

Lucia Mutikani of Reuters reports, Strong U.S. job, wage gains open door to mid-year rate hike:
U.S. job growth rose solidly in January and wages rebounded strongly, a show of underlying strength in the economy that puts a mid-year interest rate increase from the Federal Reserve back on the table.

Nonfarm payrolls increased 257,000 last month, the Labor Department said on Friday. Data for November and December was revised to show a whopping 147,000 more jobs created than previously reported, bolstering views consumers will have enough muscle to carry the economy through rough seas.

"By any measure this was an extremely good report. This report continues to add evidence that the consumer has the potential to continue to move along at this very constructive pace," said Tom Porcelli, chief U.S. economist at RBC Capital Markets in New York.

At 423,000, November's payroll gains were the largest since May 2010, when employment was boosted by government hiring for the population count.

While the unemployment rate rose one-tenth of a percentage point to 5.7 percent, that was because the labor force increased, a sign of confidence in the jobs market.

U.S. stock index futures rose on the data. The dollar rose against a basket of currencies, while prices for U.S. Treasury debt fell.

January marked the 11th straight month of job gains above 200,000, the longest streak since 1994. Economists polled by Reuters had forecast hiring increasing 234,000 last month and the unemployment rate holding steady at 5.6 percent.

The continued improvement in the labor market comes despite the economy slowing. Sputtering growth overseas and lower oil prices have weighed on exports and business investment.

Wages increased 12 cents last month after falling five cents in December. That took the year-on-year gain to 2.2 percent, the largest since August.

Interest rate hike expectations had been dialed back to September in the wake of December's surprise drop in wages.

The Fed last week ramped up its assessment of the labor market. Brisk job gains and the improvement in wages could harden expectations of a June policy tightening.

"While it's important not to over-react to one data point, there are exceptions and this is one of them. Employment growth is clearly on fire and its beginning to put upward pressure on wage growth. The Fed can't wait much longer in that environment, particularly not when interest rates are starting at near-zero," said Paul Ashworth, chief U.S. economist at Capital Economics in Toronto.


The pick-up in wages is likely to combine with lower oil prices to provide a massive tailwind for consumer spending and keep the economy growing at a fairly healthy clip, despite the global turmoil.

Growth braked to a 2.6 percent annual rate in the fourth quarter from a 5.0 percent pace in the third quarter.

While several states put in place higher minimum wages last month, that likely had a minimal impact on wages.

Economists say roughly three million workers may have been affected, accounting for just 3 percent of the private sector's more than 118 million employees.

The government revised payroll employment, hours and earnings figures dating back to 2010. The level of employment in March 2014 was 91,000 higher than previously estimated.

A new population estimate that will be used to adjust the figures from its household survey was also introduced. That survey is used to determine the number of unemployed and the size of the workforce.

Away from the firmer wages and job growth, the labor force participation rate, or the share of working-age Americans who are employed or at least looking for a job, rose two-tenths of percentage point to 62.9 percent.

The employment-to-population ratio rose to 59.3 percent from 59.2 percent in December.

But a broad measure of joblessness that includes people who want to work but have given up searching and those working part-time because they cannot find full-time employment rose to 11.3 percent from 11.2 percent in December.

In January, private payrolls increased 267,000. November and December private employment was revised higher. Private payroll gains in November were the largest since September 1997.

Manufacturing added 22,000 jobs in January. Construction payrolls increased 39,000 after rising 44,000 in December. Oil and gas extraction employment fell 1,900 last month, reflecting layoffs in the energy industry in response to lower oil prices.

Retail employment increased 45,900 after braking sharply in December. Government payrolls fell 10,000, while transportation employment dropped 8,600, the first decline since last February.

Temporary help slipped 4,100, the first drop in a year.

The average workweek was steady at 34.6 hours.
In his comment, Joe Weisenthal of Bloomberg reports, This Chart Just Screams Labor Market Liftoff (click on image below):

There's a lot to like in today's jobs report. The January gains were very strong. There were huge upward revisions to past months. Even wages beat expectations.

But the chart above (via Bloomberg's Matthew Boesler) might be the most impressive. It shows the year-over-year percentage change in non-farm payrolls. As you can see, it's starting to surge, and now the pace of employment growth (2.4%) is higher than at any time during the recovery -- this one or the last.

It really looks like the labor market is kicking into high gear.
No doubt about it, U.S. employment gains have been very impressive over the last year, and will likely continue barring another financial crisis. This is one reason why Canadian pension funds have been snapping up U.S. commercial real estate lately despite the fall in the loonie.

More interestingly, the better relative growth in the U.S. has not deterred foreign investors from piling into U.S. bonds:
Foreign investors are snapping up Treasury bonds at the fastest clip in two years, propelling yields to fresh lows even as the U.S. economy gains steam.

Purchases by China, Japan, Switzerland and others underscore the broad demand for safe government debt amid global turmoil and uneven economic growth, according to new data from the Federal Reserve and Crédit Agricole.

The overseas buying helps to unravel a mystery that has vexed commentators in 2014: How can bond prices keep rising and yields falling alongside gathering U.S. growth?

Bond-price gains have confounded Wall Street forecasters and driven the yield on the 10-year U.S. note to 2.12% Monday from 3% at the end of 2013. Many strategists entered the year expecting U.S. yields to approach 4%, though most have downgraded those projections.

Many analysts and portfolio managers say the foreign demand for U.S. Treasurys likely will help moderate any bond selloff in 2015, despite widespread investor expectations that the Fed for the first time since 2006 will raise its short-term federal-funds interest-rate target.

Many nations, including China, purchase U.S. debt to manage their exchange rates and increase their export-related industries.

At the same time, U.S. bonds likely will benefit from any market unrest centering in emerging markets, traders and investors said. Treasurys have long been sought after by those seeking safety when market volatility picks up and the prices fall on risky assets like stocks and low-rated bonds, as seen around the globe in recent days.

“Lower long-dated Treasury yields are here to stay,” said Guy Haselmann, head of U.S. interest-rate strategy at Bank of Nova Scotia in New York.

Foreign central banks and private investors bought a net $284 billion of Treasury debt over the first nine months of 2014, according to Jonathan Rick, interest-rate derivatives strategist at Crédit Agricole. That compares with $83.2 billion over the equivalent stretch in 2013, a period that included the so-called taper tantrum in which investors sold Treasurys en masse as the Fed prepared to begin rolling back its monthly stimulus.

To be sure, the overseas buying remains well below its peak following the 2008 financial crisis and the 2011 eurozone debt crisis.

But tumbling oil prices have helped crystallize investor worries over stagnant growth in the eurozone and Japan and slowdowns in many emerging-market countries.

U.S. bonds continue to offer more-attractive yields than other bonds in the developed world, and a stronger dollar—which many analysts expect to rise further in 2015—enables foreign investors to pick up extra returns on U.S. investments.

On Monday, the yield on 10-year government bonds was 0.375% in Japan, 0.625% in Germany, 0.897% in France and 1.807% in the U.K.

China has bought a net $155 billion of Treasury debt this year through September, according to data from the U.S. Treasury. The data exclude bonds maturing in a year or less, known as bills.

Holdings rose a net $39.3 billion in Japan, $16.9 billion in Brazil and $9.5 billion in Switzerland. Belgium, which analysts say is used by nations including China for Treasury transactions, rose $97 billion.

Some analysts say demand from China, the biggest foreign owner of U.S. Treasury debt, with $1.27 trillion at the end of September, could slow along with economic growth there.

A rising dollar has weakened many foreign currencies, the yuan included, as investors brace for rising U.S. rates in 2015. That shift potentially will reduce the need for China to sell its currency and buy Treasurys with the proceeds to keep the yuan’s exchange value down.

“Given the big picture of an economic slowdown, a weaker yuan and China’s inclination to get into other investments, their buying of Treasury bonds should be on a structural decline as a longer-term trend,’’ said Stanley Sun, interest-rate strategist at Nomura Securities International in New York.

But Tom Tucci, head of Treasury trading in New York at CIBC World Markets Corp., is confident that “as long as the dollar remains strong,” China and other investors will be buyers.

Not everyone is sold. Michael Cloherty, head of U.S. interest- rate strategy in New York at RBC Capital Markets, expects the 10-year Treasury yield to climb above 3% at the end of 2015.

“The bond market rally this year has caught many by surprise, but the rally is overdone,’’ said Mr. Cloherty. ”Yields at these low levels haven’t priced in higher interest rates from the Fed.”

Regardless, buying U.S. Treasury bonds has been a winning strategy this year for investors. The debt has a total return, reflecting price appreciation and interest payments, of 5.3% this year through Friday, according to Barclays PLC. Over the same period, the S&P 500 has returned 15% and low-rated corporate bonds 0.8%.

U.S. banks also increased Treasury debt holdings by $141.9 billion between January and September, following the imposition of rules aimed at beefing up banks’ capacity to withstand future shocks.
The WSJ article above was written back in mid-December but it explains why U.S. bond yields continued to decline early this year. Foreigners searching for safe yield are piling into U.S. bonds, driving yields lower and propelling the U.S. dollar higher.

And by the way, the surging U.S. dollar is actually buying the Fed time before it even begins contemplating raising rates because it's tightening U.S. financial conditions, a point underscored in a tweet by Justin Wolfers on Friday morning (click on image):

But as I explained in my comment on the mighty greenback back in October, the surging U.S. dollar is weighing on earnings of multinationals and reinforcing deflationary pressures within the United States:
What does the strong USD mean for the U.S. economy? It means oil and import prices will drop and exports will get hurt. Ironically, lower oil and import prices will reinforce deflationary headwinds, which isn't exactly what the Fed wants. But the stronger USD might also give the Fed room to push back its anticipated rate hikes. Why? Because the rise in the USD tightens up financial conditions in the U.S. economy, acting as a rate increase.

In terms of stocks, the surging greenback may be a triple whammy for U.S. earnings. Multinationals which as a group derive almost half of their revenue from international markets, will see a hit on their earnings, especially if they didn't hedge accordingly. But you should see small caps (IWM), which have been beaten down hard in September and thus far in October, rally as they're more exposed to the domestic market.
Conversely, the rising dollar and weakening euro might be exactly what the ailing eurozone needs right now (watch this CNBC clip on how Fiat-Chrysler is reaping the benefits of a soaring U.S. dollar). It will boost exports in Germany, France and elsewhere and boost tourism to Greece and other southern European countries this summer. 

But will this be enough? With Germany threatening to push Greece over the edge, I'm far from convinced that a lower euro will cure the deep structural imbalances that plague that continent.

Please go back to read my comment on why this time is really different, where I stated the following:
The "Made in the USA" viewpoint rightly notes that in the past, it's always been the U.S. economy which leads the world in and out a global recession. My own research on Galton's fallacy and the myth of decoupling made me highly suspicious of American economic naysayers hailing a new economic paradigm shift was taking place where emerging market economies would lead the world.

This is utter nonsense but plenty of institutional investors are still buying this sell-side fairy tale hook, line and sinker. But while the U.S. is still the economic engine of the world, there is no denying that globalization is much more important now than at any time in the past.

This brings me to the second way of thinking of the world, the non-U.S. centrist view, which basically says we need to pay a lot more attention to what's going on in the rest of the world because it can spill over into the U.S. and wreak havoc on the global economy.

Those of you who regularly read my blog know that deflation is a central theme I obsess over. Why? Because it's THE most important theme to understand in terms of the macro environment and if you're on the wrong side of the deflation trade, you risk getting crushed.

There are plenty of global macro hedge funds which learned this lesson the hard way in 2014 --  getting their calls right shorting the yen, the euro and going long equities -- but getting obliterated on their short Treasuries trade. Many long/ short equity funds also suffered big losses in 2014 because they failed to understand the macro environment, and got clobbered on their long energy trades.
On that note, I urge you all to go back and read my Outlook 2015, to understand why even though this will a rough and tumble year, there are plenty of opportunities to make money in bonds and stocks this year.

In this environment, investors should overweight small caps (IWM), technology (QQQ or XLK) and biotech shares (IBB or XBI) and keep steering clear of energy (XLE), materials (XLB) and commodities (GSG). And even though deflationary headwinds are picking up, I'm less bullish on utilities (XLU) healthcare (XLV) because valuations are getting out of whack after a huge run-up last yearThose of you that bought the dip on Twitter (TWTR) over the last couple of months can thank me by sharing a small percentage of your gains and supporting my blog. 

Finally, the latest U.S. jobs report doesn't change my view on the Fed staying put in 2015. I think international developments are going to take precedence and the surging greenback will buy the Fed time to carefully assess whether a rate increase is desirable or warranted.

Importantly, if the Fed focuses solely on the domestic economy ignoring global deflation and goes ahead and raises rates in June, it will be making a monumental mistake, possibly ushering in an epochal deflationary crisis.

Also, I agree with the editors of Bloomberg, the Fed still needs to consider the outlook for inflation and this jobs report isn't enough to start raising rates:
The main problem is that the headline rate of unemployment excludes other measures of underemployment -- in effect, hidden labor-market slack. These worsened during the recession. At the end of last year, almost 9 million people were unemployed. Excluded from that number were 2.3 million more who wanted a job but hadn't "actively" looked for one in the previous month; also excluded were 6.8 million part-time workers who would have preferred to be working full time.

It's impossible to say exactly how much extra patience from the Fed this disguised unemployment should justify, but keep another point in mind. Inflation is currently running at less than the Fed's target of 2 percent, and the recent strength of the dollar will help to keep it there. A temporary modest undershooting of the target is no great cause for concern -- but the same goes for a temporary modest overshooting. Indeed, if the Fed interpreted its target as a ceiling, never to be exceeded, then over time inflation would average less than 2 percent. To hit the target over time, occasional small overshoots are actually necessary.

In short, there may be more slack in the labor market than the standard measure suggests, and there's some latitude on inflation as well. Rather than trying to anticipate higher inflation, as it might under normal circumstances, the Fed should wait until it sees the whites of its eyes. At the very least, it should wait until it sees either actual inflation or sufficient labor-market tightening to cause wages to rise -- of which, as yet, there's also no sign.

Patience is a virtue. And there's never been a better time for the Fed to be virtuous.
Others like Philadelphia Fed President Charles Plosser, a well-known hawk who is leaving the Fed, think otherwise. Below, he shares his thoughts on Friday's jobs data and what it indicates about the U.S. economy. Plosser also explains why he thinks it's hard to justify zero interest rates at this time.

Many underfunded pension plans hope he's right but my biggest fear remains that deflation will decimate pensions. This is why I hope the Fed is not seriously on the cusp of raising rates.

Lastly, I thank all of you who have donated and/or subscribed to my blog but will ask others to please show your financial support for my comments via PayPal on the top right-hand side. I realize the blog is free but it's only fair to ask many of you who regularly read me, especially those from institutions paying thousands of dollars to private research outfits, to support my efforts. Thank you.

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