US UNEMPLOYMENT FALLS TO 4.5 %, THE LOWEST IN A DECADE, MAY FORCE THE FED TO RETHINK MONETARY POLICY.
The U.S. jobs report on Friday provided Federal Reserve officials with a surprise. Unemployment in March had already declined to the level they’d expected it to hit by the end of 2017.
That combined with what some economists viewed as another head-scratcher.
Even as unemployment fell to 4.5 percent, its lowest level in almost 10 years, wages remained on just a gentle upward path. Average hourly earnings rose 2.7 percent year-on-year, essentially the same as the average over the previous 12 months.
How policy makers react depends on how they unravel that riddle. If they conclude that it’s only a matter of time before falling joblessness triggers a stronger response in wages and prices, the Fed may be inclined pick up the pace of rate increases.
Their current set of projections points them toward three total hikes this year, including a March move already in the books.
But there’s another option. They could decide to lower their estimate for the level at which unemployment becomes inflationary — the so-called non-accelerating inflation rate of unemployment, or Nairu. That would justify sticking to their current outlook for rates.
“There’s a good chance we’ll see them revising the Nairu downward” when Fed officials submit new projections in June, said Thomas Costerg, senior U.S. economist at Standard Chartered Bank. “The Fed is flying a bit in the dark on Nairu. The canary in the coal mine is wage growth, and the fact is wage growth remains tepid.”
It wouldn’t be the first time central bankers shifted that estimate.
Nairu is the term now in fashion for what Nobel Prize-winning economist Milton Friedman first described in 1968 as the “natural rate of unemployment.”
First thought of as a fixed level, Nairu is what economists now see as a trigger point that can move substantially over time. As recently as 2013, Fed officials estimated Nairu in the U.S. around 5.6 percent.
After unemployment hit its Great Recession peak of 10 percent in 2009 and kept on falling without triggering much movement in inflation, they revised their estimates downward. Expressed in Fed projections as the “longer-run” estimate for unemployment, the median level of their estimates now sits at 4.7 percent.
“They’ve already overshot on their measure,” said Allen Sinai, president and co-founder of Decision Economics in New York who also thinks Fed officials will ratchet down their estimates in June.
For the March U.S. employment report, with its ugly headline payrolls number, it’s what’s inside that counts.
While the gain of 98,000 jobs in a survey of businesses and government agencies was the weakest since May and below all analysts’ forecasts, many accompanying details showed a solid labor market.
The jobless rate, derived from a separate survey of households, fell to the lowest in almost a decade even as workforce participation was unchanged, while a measure of underemployment reached a fresh post-recession low, boding well for further wage increases.
“Aside from the payroll data, all the other underlying details are encouraging,” said Tom Simons, an economist at Jefferies LLC in New York. “People are re-entering the labor force and it looks like they’re getting jobs right away. The participation rate being steady is encouraging there.”
The March data from the Labor Department on Friday also were challenged by weather anomalies — a storm in the Northeast during the survey week and more seasonable temperatures after two warmer months — that had economists bracing for at least some slowdown in payrolls from a strong start to the year.
Weather effects probably explain about 70,000 of the difference in payroll gains between February and March, according to Goldman Sachs economists.
The reassuring figures elsewhere in the report keep the Federal Reserve on track to continue plans for two more interest-rate increases this year as the labor market continues to tighten.
“The Fed is going to look past the March weakness — they’re going to continue to paint a positive picture of the labor market,” said Ryan Sweet, an economist at Moody’s Analytics Inc. in West Chester, Pennsylvania. “The trend in job growth remains solid and the overall economy is still doing well.”
Even so, there wasn’t much to sing about in the March payroll figures. The employment increase included a paltry 6,000 gain in construction jobs and 11,000 in manufacturing after both sectors showed big gains in January and February.
Among services jobs, retailers were hit hard last month. That industry showed the weakest two months for hiring since the end of 2009, battered at least in part by the broader trend of Americans flocking to online merchants rather than brick-and-mortar stores.
But for a labor market that’s already challenged by a dwindling supply of unemployed workers, the report may be flashing more warning signs of overheating than of cooling.
The jobless rate fell for what economists often deem “the right reasons” — meaning that more people were employed and fewer were unemployed — not as a result of Americans fleeing the labor force in discouragement, or retirement.
US Treasuries rose on Friday to end the week 10 basis points lower.
Furthermore, even with the bond market’s muted response to the Federal Reserve’s plan to begin winding down its almost $4.3 trillion portfolio of mortgage and Treasury securities, there are plenty of reasons why the calm probably won’t last.
Out of style for almost a decade, volatility may be on its way back if you take a closer look at the mechanics of the Treasury and mortgage markets. Despite the Fed’s mantra of seeking to carry out its policy shift in a “gradual and predictable manner,” analysts say the effects of ending the reinvestment of the proceeds from maturing securities will still be felt.
This is the “most highly anticipated event in central-bank history,” said Walter Schmidt, senior vice president of structured products at FTN Financial in Chicago. “We’ve known this for two years. We’ve been waiting for this.”
While the three rounds of Fed asset purchases that became known as quantitative easing sapped volatility, former Fed Chairman Ben Bernanke’s comments in May 2013 that the central bank was considering scaling back purchases showed how quickly that can change. The so-called taper tantrum sent yields surging.
As the Fed begins to unwind, here are four reasons why we may see a renewal in volatility:
1. MBS Supply/Demand Shift
The Fed owns $1.77 trillion of agency mortgage-backed securities, about 31 percent of the market. As the central bank’s MBS holdings begin to roll off, mortgage spreads to Treasuries are going to have to widen to adjust for the additional supply, which some analysts estimate will begin at around $5 billion a month.
Since the Fed concluded quantitative easing in October 2014, the spread between Fannie Mae 30-year current coupon and Treasuries has been sitting between 90 and 114 basis points, below its historical average of about 137 basis points.
Mortgage spreads may widen five to 10 basis points once the market prices in a certainty of tapering reinvestments and another 10 to 20 basis points over the longer term, Citigroup Inc. analysts estimate.
2. Increased Convexity Hedging
If the Fed decides to pause interest-rate hikes while letting the balance sheet shrink, mortgage rates are still going to rise because a large source of demand is disappearing. As a result, prepayment speeds, the pace at which borrowers pay off loans ahead of schedule, are going to fall, which will cause the duration of the securities to increase.
It’s still a double whammy if the Fed continues to raise rates. Fed tightening would push up the effective fed funds rates, also reducing prepayment speeds and increasing the average duration of the securities.
When rates rise, hedging against so-called convexity risk grows as the expected life of mortgage debt increases. That happens when refinancing slows and tends to leave holders more vulnerable to losses as lower-duration securities are more vulnerable to rising rates. By protecting against those potential losses (selling Treasuries or entering into swaps contracts), traders can end up making the bond market more turbulent.
3. Rise in Term Premium, Withdrawal from Risk Assets
As the market prepares for the Fed’s unwind, it should place upward pressure on the 10-year term premium, a measure of the extra compensation investors demand to hold a longer-term instruments instead of rolling over a series of short-dated obligations.
The premium could rise 47 basis points over the course of 2018 and 2019 due to the reduction in duration, according to Bank of America Merrill Lynch strategists. Higher term premiums, coupled with increased mortgage duration could also cause a steepening of the five- to 10-year yield curve.
There’s also a chance that an increase in term premium triggers a withdrawal from risk assets such as equities, which have risen to record highs during almost a decade of accommodative Fed policy, though “the risk asset link is not as certain,” according to Bank of America strategist Mark Cabana.
4. Surge in Front-End Treasury Rates
The front end of the Treasury market will have its own set of issues when the balance sheet starts to shrink.
The Treasury Department will have to decide which portion of the curve it wants to issue more securities: The front-end, where Treasury bills outstanding comprise less than 13 percent of marketable debt, or the long-end to take advantage of 30-year bonds trading around 3 percent.
“Treasury is going to need to increase front-end supply pretty notably,” Cabana said. “Banks losing reserves will be looking to replicate those assets.”
Assuming Treasury ramps up bill supply, rates on debt maturing in less than one year would likely rise, forcing up the overnight rate on Treasury repurchase agreements. That may cause usage at the Fed’s fixed-rate overnight reverse repurchase agreement facility to sink, as investors will pivot away from the operation.
“Overall, this should pressure rates higher, with banks having relatively more securities to finance in the repo market as time goes on,” said Scott Skyrm, managing director at Wedbush Securities in New York.
In Europe, investors are in wait-and-see mode
German factory orders rebounded from their steepest decline in eight years in a sign the recovery in Europe’s largest economy remains intact.
Orders, adjusted for seasonal swings and inflation, rose 3.4 percent in February, after slumping a revised 6.8 percent in January, data from the Economy Ministry in Berlin showed on Thursday.
The typically volatile reading compares with a median estimate for a 4 percent gain in a Bloomberg survey. Orders were up 4.6 percent from a year earlier, when adjusted for working days.
Germany’s economy expanded at the fastest pace in five years in 2016 and recent data show that trend is set to continue with private-sector output accelerating, unemployment falling to a record low and business confidence at the highest since 2011.
Even so, risks including September’s federal elections, Brexit and uncertainty over U.S. trade policies continue to hang over the outlook for spending and investment.
The rebound was led by a 8.1 percent jump in domestic demand, while export orders were unchanged from January. Intermediate-goods orders surged 8.5 percent in February, while demand for investment goods rose 0.3 percent and that for consumer goods increased 2.7 percent, the ministry said.
“Manufacturing orders recovered after a sharp decline at the start of the year,” the ministry said in an e-mailed statement. “Order intake was lower than in the very strong fourth quarter, which was characterized by bulk orders.
However, the volume of orders as well as the business climate in the manufacturing sector rose” and “a slight upturn in manufacturing is to be expected,” the ministry said.
As a confirmation of the trend, German industrial production unexpectedly rose in February, led by the construction sector, reaffirming the strength of the country’s economic outlook.
Output, adjusted for seasonal swings and inflation, gained 2.2 percent from January, when it rose a revised 2.2 percent, the Economy Ministry in Berlin said on Friday.
Production was up 2.5 percent from a year earlier.
Citigroup responded to the production numbers — and an increase in exports in February — by raising its estimate for first-quarter economic growth to 0.7 percent from 0.5 percent, which would be the strongest performance in a year.
Brexit and uncertainty over U.S. trade policies could still pose risks for spending and investment in Europe’s largest economy.
After cold weather held back construction in previous months, it surged almost 14 percent in February. Output of investment goods increased 1.1 percent and consumption goods rose 1.4 percent.