The very sharp drop in yields on U.S. Treasuries on Friday suggests that the fixed-income markets have interpreted the last week's disappointing jobs report as an indication that the economy is facing diminishing demand momentum. As a result, traders significantly lowered their expectations of an interest rate hike by the Federal Reserve this summer, which also drove down yields elsewhere in the world.
This reaction is understandable, but it is but one of three possible conclusions to be drawn from the jobs report for May released Friday. The other two hypotheses are a lot less definitive about demand as well as the outlook for wages and inflation. And because each of the possible conclusions has some supporting evidence, none should be treated as dominant, at least yet, which may suggest that Friday’s market moves could have been an overreaction.
Undoubtedly, job creation in May was disappointing: Just 38,000 positions were added, far below the consensus expectations of about 160,000. And to make matters worse, the data for March and April were revised downward by a combined 59,000 jobs.
With a large drop in yields of around 10 basis points for both 2-year and 10-year Treasury bonds, the fixed-income markets immediately signaled notable concerns about the prospects for U.S. demand and therefore economic growth and inflation. As a result, market participants essentially took a June interest rate hike completely off the table while significantly delaying expectations for the timing of any subsequent raises as well as their frequency. After all, the Fed had already expressed concerns about the fragility of the global economy and the resulting headwinds for U.S. growth, which has yet to reach “escape velocity.”
But that analysis holds only if the hypothesis of challenged demand turns out to have been correct. The other two possible explanations for the weak jobs data, if relevant, would qualify the markets’ conclusion.
One month’s numbers do not confirm a turning point. This is especially true of the inherently noisy monthly employment data. Moreover, there are other indicators suggesting that the U.S. economy, though far from excellent, continues to move forward. This data fluidity should lead to greater caution about any overly deterministic conclusions about the impact of Friday’s report, especially given that it contradicts the trend that was apparent in many of the previous months' employment data.
The third possibility is that the disappointing job-creation numbers have more to do with supply than demand. After all, the already frustratingly sluggish participation rate dropped by 0.2 percent, to 62.6 percent, very close to its historical low. Simultaneously, wages grew by 0.2 percent in May, which brought the year-on-year increase to 2.5 percent. These add to other signals that are consistent with the view that the U.S. labor force may be experiencing the beginning of a skill-mismatch problem -- though the data remains extremely partial and highly anecdotal.
For now, there is insufficient information to determine which of these three hypotheses will prevail. Indeed, all three could be in play at present, adding to the “unusual uncertainty” facing policy makers at the Fed.
This isn't to say that the Fed may in fact raise interest rates when its policy-making officials meet next week. It won’t. The probability of that happening was already constrained by the uncertainty surrounding the referendum on the U.K. membership of the European Union later this month.
But it does suggest that it may have been premature for markets to make such drastic changes to the outlook for interest rates for the rest of the year. And if they did come to a conclusion too hastily, as I suspect, investors will continue on a quite volatile interest rate journey this year as expectations for Fed actions fluctuate.