Markets have had a full week to digest the very strong U.S. jobs report, as well as signs of progress in the China-U.S. trade talks. Yet despite the positive news, investors and traders believe the Federal Reserve will stop hiking interest rates this year and will cut them in both 2020 and 2021. The discrepancy between the markets’ interest rate view and the positive jobs report, and how this difference is eventually resolved, have important implications for investment strategies in the New Year.
The blowout employment report released Jan. 4 showed that the U.S. economy created 312,000 jobs in December, almost twice consensus expectations. Adding to signs of a strong labor market, the previous two months' readings were revised upward and wage growth rose to 3.2 percent, suggesting that the household sector, the main driver of growth in the U.S. economy, is strong. This positive sign for consumption would normally encourage companies to boost output and capacity, adding to the growth impetus. In addition, the budget approved by the previous Congress contains continued fiscal stimulus for this year.
Yields on U.S. Treasuries moved up from their depressed levels at the market close on Jan. 3, the day before the release of the jobs reports. The 2-year bond rose to 2.54 percent on Jan. 11 from 2.38 percent, and the 10-year to just over 2.70 percent from under 2.60 percent. Yet overall levels remain relatively low given the strength of the labor market data. Moreover, the difference between these two maturities, historically regarded as a signal of growth prospects, remains at a worrisome low level of 16 basis points.
The contrast between the implied market pricing for the fed funds rate and the central bank’s “blue dots” is also notable. The markets, anticipating no hikes this year and cuts thereafter, estimate the fed funds rate in 2020 a full percentage point below the median of the central bank's dots.
Several reasons have been put forward to explain this striking and consequential difference. They include the following six (which aren't mutually exclusive):
Structural upside to the U.S. economy: With the jobs report showing a 0.2 percentage uptick in the labor participation rate (to 63.1 percent from 62.9 percent), combined with higher wages and ample job opportunities (the JOLT data of vacancies came in again at about 7 million), discouraged workers may be more inclined to re-enter the labor force. Together with the hope of a pickup in what has been unusually sluggish productivity, that development would enable the Fed to “let the economy run” without fear of the type of inflation and/or market instability that would subsequently damage growth and economic well-being. Such supply-side improvements would allow low interest rates to prevail with strong growth, and even more so if Congress and the administration are able to agree on a pro-growth and pro-productivity infrastructure initiative, which both political parties have favored in the past.
The Fed has been again cowed by markets: In this view, the discrepancy between the market expectations of future Fed policy leniency and the strength of the economy is the result of what markets have gotten used to, continue to demand, and are confident they will get again: ample liquidity from central banks. Advocates of this position note that every time the Fed looks to take away the punch bowl, the markets throw a fit and force it to reverse course. This happened repeatedly when Ben Bernanke and Janet Yellen chaired the Fed. Recent changes in the policy guidance from the Fed under Jay Powell signal that the central bank's earlier attempts to be different have proved short-lived. And it is just a matter of time until the European Central Bank is forced back into buying securities under its quantitative easing program, with beneficial liquidity spillover for the U.S.
The economy is fine but politics could interfere: This is the first of the explanations that cast doubt on the future strength of the U.S. economy. The ongoing government shutdown, the longest in U.S. history, feeds worries that the divided Congress resulting from the November midterm elections will bring greater political polarization that undermines an otherwise healthy economy.
Backward-looking data is at odds with forward indicators: Some argue that that latest labor report is not sufficiently forward-looking, even though it is an accurate snapshot of past and current economic strength. To support this view, these analysts point to other data releases (particularly the decline in recent measures of confidence and expectations for future economic activity).
The rest of the world is getting worse by the day: Those who espouse this view acknowledge the standalone strength of the U.S. economy but worry it could be vulnerable to spillovers from conditions elsewhere. Europe's economic numbers are turning even more worrisome, and there is little evidence yet of the beneficial impact of more Chinese stimulus measures. This analysis reflects concerns that it may be just a matter of time before weakness in these two major economic areas drags down the U.S. and starts bringing to a close an impressive period of American economic divergence and consistent outperformance. To support this stance, some point to the yield difference between 10-year U.S. and German government bonds, which has narrowed in recent weeks from a high of 280 basis points to now below 250 basis points.