Non-Farm Payroll Report Excites, but Harkens Back to February Mini-Crash

Tom Cleveland

It is a strange investment world that we live in today, where good news about the economy is not actually what everyone wanted to hear. Why is this so? Friday’s Non-Farm Payroll report, the one data release that has always been the biggest mover and shaker in the market, especially in the forex arena, beat all expectations not only on the jobs and unemployment data points, but also, more importantly, on the YOY increases in the Average Hourly Earnings figure. Analysts were laser-focused on this one item, since, for months, inflation in this area had been anticipated, but had never come to pass.

Why was this good news suddenly regarded as bad? The specter of rampant inflation raised its ugly head to the surprise of all, and many investors, analysts, and traders were experiencing déjà vu all over again, as it were. As one analyst quipped after taking a ride down memory lane: “Friday, February 2, was the last time the market was taken off guard by a well-above-consensus Average Hourly Earnings print. That was the fateful Friday that presaged a week during which the VIX staged its largest one-day spike in history and the Dow (DIA) fell more than a 1,000 points on two separate occasions.”

Bloomberg produces a particular chart that tracks something called the “annual weekly correlation of S&P total returns and bond returns” versus short and long-term bond spreads to arrive at the presentation below:

Bloomberg’s Ye Xie noted that, “This will be the first week when both Treasurys (TLT) and the S&P 500 had losses since May. During the previous two economic cycles, the bond/stock correlation flipped to positive when the curve inverted, meaning we could have simultaneous sell-offs in bonds and stocks, as bonds no longer work as an ideal hedge against equities when the curve inverts.” The left axis applies to the yield–curve white line. It is presently approaching an inversion, as is the correlation figure.

It is amazing that one chart could have generated such fear in the streets, but the analyst community is an edgy group, plagued by nightmares of imminent Armageddon, just around the corner. If and when the big sell off occurs, there will be nowhere to hide. It is already a given that Trump’s tax plan and stimulus spending will balloon the deficit, such that, “When the next downturn finally comes along, the scope for a fiscal response will be severely constrained, putting the onus squarely on monetary policy.”

And where does the Fed fit in this desperate scenario? John Williams, the President of the New York Fed, recently asserted in a speech that, “The central bank shouldn’t be afraid to invert the yield curve.” This statement was an anathema to most every technical guru on the planet, many of whom had written previously that a yield-curve inversion was the most reliable indicator we had for forecasting that a recession would occur within the following 12 to 18 months. The probability for a rate increase this month is above 99%, and the Fed will surely reduce the size of its balance sheet post haste. In other words, is the noose being tightened too quickly on this economy? Has it peaked?

That was Friday. Today is Monday, and the proverbial sky is not falling. Stock markets are on even keel, having absorbed whatever hysteria was created before the weekend. Volatility, as measured by the VIX barometer, is barely above 14.5, the average for stability being roughly 12.5. Perhaps, a few indicia were different way back there in February or scar tissue has blunted this repeat performance, but the focus, now, if you will, shifts back to tariffs, emerging markets and China, and potential impacts on the U.S. Dollar, other exchange rates, and commodity prices.

What were the good and the bad details regarding the NFP jobs report?

Here is just one summary of the NFP jobs report: “The August US jobs report shows payrolls rose 201,000 versus the 190k Bloomberg consensus. July was revised down 10k with a 40k downward revision in June. The unemployment rate remained at 3.9%, but the big story is the pick-up in wages. It surged 0.4% month on month to 2.9% year on year versus the consensus 0.2% MoM/2.7% YoY. This report is strong throughout, and with the economy likely to grow more than 3% again in 3Q18, it will keep the Fed hiking interest rates with another move in September with a further increase in December.” To say the market was caught off guard would be an understatement.

NFP Report

The unemployment figure back in May was 3.8%, although the current 3.9% is extraordinary in its own right. One must go back more than fifty years to find a rate lower than 3.8%. The concern that has been noted many times in previous quarters is that such low unemployment should put pressure on wages, in line with the correlation depicted in the following chart (The Unemployment axis has been inverted to better reflect the correlation):

Wages rate trend

Yes, hourly earnings have grown from beneath a 2% clip to 2.7% since the Great Recession, but Real Wages, i.e., adjusted for inflation, have not – See below:

Real Wages trend

Many economists and reporters have referred to this chart as the “elephant in the room”, since it all but negates the gains illustrated in the previous diagram. Of greater significance, however, is the fact that our economy is consumer driven. Without wage increases, households must resort to borrowing or spending savings. Yes, total household debt had dipped from the $12.7 trillion figure back in 2009, but it has crept up past that figure today. The savings grace is that the economy has grown and interest rates have dropped. Whereas total household debt was 98% of GDP in 2009, it has now fallen into the low eighties. Debt service is also 2.5% less of disposable income, so we do not have a household debt crisis at our door.

As for a current real wage growth data point, we will have to wait until new CPI figures come out next week. For the time being, we can appreciate that, even however slowly the rise, hourly wages are escalating, or as one analyst noted: “Friday’s AHE data supports the contention that the fabled “missing” wage growth isn’t really “missing” anymore. Indeed, the AHE print comes a little over a month after the latest read on the ECI showed U.S. employment costs rising 2.8% YOY, the most since Q3 2008.” It is good news, even if its ramifications may be difficult to swallow.

Amidst these good and bad takes of the news, what is the outlook for currencies?

We still have three weeks to go before the end of the current quarter, plenty of time for major currency pairs to jostle about, searching for that much desired equilibrium point. Here are a few comments to weigh in on your trading strategies going forward:

The U.S. Dollar

Here is just one opinion that echoes what many are thinking: “We believe the US dollar is caught between two trends. Interest rate hikes and balance sheet reduction by the US Federal Reserve (Fed) have increased US dollar funding costs and tightened financial conditions, spurring the dollar rally. Uncertainty over trade policy has exacerbated the move. On the other hand, global growth has been strong and it appears that US economic activity, while buoyant, has peaked – a convergence that typically causes the US dollar to weaken.” The U.S. Index hovers around 95, its resting place for quite some time, providing support time and again, but climbing over 97 has been difficult, and will be more so, if the U.S. economy has actually “peaked” versus the rest of the world.

The Euro

Mario Draghi may have exhausted his ability to bolster the Euro’s fortunes based upon his rhetoric alone. The recent economic news from Germany has not been encouraging, and the emerging market capital crisis has increased risk aversion tendencies across the continent. Brexit is still an issue, and Italy and Spain are resolved to contest current budget rule requirements in order to put their respective financial affairs in order. Back in January, the Euro hit 1.255, but it has been downhill since April, settling in a tight range between 1.17 and 1.13. It now is at 1.16. The ECB will meet on September 13. Current tensions may prevent Draghi from getting too boisterous. The ECB will more than likely begin to taper QE (It is set to end at the end of 2018). Keep in mind that the Euro has fallen on the day of each of its last seven meetings in a row. There also appears to be an inverted Head-and-Shoulders pattern in place, which would be favorable in the near term. If the single currency can keep its head above the 1.153 region, then good things could happen. Also remember that traders have lost fortunes shorting the Euro.

Pound Sterling

The British Pound has traversed a path similar to the Euro, harkening back to 1.435 in January, in freefall since April, and settling at a current valuation of 1.30. The Pound will continue to be event driven, depending upon Brexit negotiations. Forecasting the timing and nature of those events is tantamount to predicting the wind. Trade elsewhere.

The Japanese Yen

The Yen has been on a weakening path for 2018, beginning at 105 and moving inexorably to 111, where it has been held hostage since July. The Yen has benefited from the rise in risk aversion brought about by the emerging market crisis, i.e., Turkey and others. The Bank of Japan may find the current 110 area attractive and provide support. If the USD strengthens, the Yen may suffer, but it might outperform against other majors.

The Australian Dollar

Like it or not, this commodity currency is tied at the hip to whatever transpires in China. As one forex expert noted: “The Australian dollar continues to struggle as the country remains in the crossfire of the trade war between the US and China. Commodity prices remain under pressure.” In fact the “April Slide” versus the USD, if you will, born out in the Chinese Yuan chart below, began earlier for this currency, and the Reserve Bank of Australia does not seem inclined to raise interest rates. Going long the Aussie is not a suggested trade at the moment, as long as China moderates.

Chinese Yuan vs USD

Concluding Remarks

Wage inflation in the U.S. brought back horrifying memories of the mini-crash back in February, but Armageddon was nowhere to be seen this Monday. The focus now naturally shifts back to tariff wars, the Fed, and yield-curve inversions.

Stay Tuned!

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Tom Cleveland
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