Steve, 1 curious point from Barron's, how is it that manufacturing jobs plunged in a month that saw record automobile sales?
Maybe the Fed Isn't Finished After All
By William Pesek Jr.
Global financial markets breathed a sigh of relief Friday as a softer-than-expected U.S. employment report reduced the odds of a Federal Reserve rate hike in October. But that doesn't mean policy makers are done for the year. In fact, the balance of last week's economic reports and comments by a key Fed official increased the chances of another tightening this year.
News that the economy created just 124,000 non-farm payroll jobs in August and that average hourly earnings rose a modest 0.2% comforted investors bracing for much larger increases. But by no means was the August jobs report "weak." Rather, it was weaker than jittery financial markets around the globe feared. "There's still a lot of oomph in the labor market and the economy in general," says Donald Fine, of Chase Asset Management.
If the economy is losing steam, the slowdown is unfolding very slowly. Yet, as Stuart Hoffman of PNC Bank points out, the latest employment report gives the Fed latitude to stand pat in October and take a couple of months to assess how its two rate hikes this year have affected the economy. At this point, most Fed watchers think policy makers are more likely to tighten at the November 16 Federal Open Market Committee meeting than on October 5.
Indeed, this stands in contrast to what observers thought just days ago. At the start of last week, most analysts, pundits and journalists (including yours truly) were thinking the central bank would take the rest of the year off, satisfied it had raised short-term rates enough to damp inflation pressures. The Fed seemed to tell us just that in the statement that accompanied its August 24 action. But last week, the tightening watch resumed.
In response, investors held a fire-sale on Treasuries for the first four days of the week. The market was unnerved by the dollar's declines versus the yen, a six-point surge in the inflation component of the August national purchasing managers' survey, and hawkish comments from Fed Governor Edward Kelley. The preponderance of bad news left most players on the same side of the market going into Friday's jobs report: Bracing for a strong number and a major selloff. Late Thursday, the 30-year bond yield was 6.13%. But when the data didn't confirm the worst fears, markets rallied, pushing the yield to 6.02% late Friday.
The euphoria may not last, however. One reason is skepticism about the accuracy of the August employment figures, many of which didn't square with other data. For example, state unemployment insurance claims have been under 300,000 for six straight weeks, a sign of a strong labor market. Also, the loss of 63,000 manufacturing jobs doesn't jibe with private industry data; the employment component of the national purchasing managers' survey is now at its highest point in 11 years, while reports from personnel firms generally point toward rising demand for jobs in the sector. Finally, how is it that manufacturing jobs plunged in a month that saw record automobile sales?
Labor Daze
Most likely, the August figures were a payback for robust job growth in the prior two months, and we could see a rebound in September. One figure that made perfect sense was the national unemployment rate, which fell to a 29-year low of 4.2% in August from 4.3%. The rate should raise eyebrows at the Fed, considering that productivity growth slowed in the second quarter while unit labor costs rose sharply. Productivity at non-farm businesses advanced at an annual rate of 0.6% between April and June, a downward revision from a previously estimated 1.3% rate. Labor costs rose 4.5%.
There are other signs that inflation may perk up. Commodity prices are at the highest since November. Business and consumer confidence are upbeat. The stock market is near all-time highs. The weakening dollar is making U.S. exports more attractive and providing less insurance against higher import prices.
Then there are the recent rumblings on the organized labor front. After years of defeat and paltry wage gains, some unions are winning hefty pay increases, raising the specter that our historically tight employment markets may finally cause wage inflation. In one marquee-caliber victory, machinists at Boeing won a 10% bonus and annual salary increases of 4% for two years and 3% in the third year. In another, Northwest Airlines offered flight attendants pay raises averaging 25% over five years and an average 80% boost in pension benefits.
But one of the most persuasive arguments for another Fed tightening this year came from Kelley. The Fed's longest-serving governor told a financial news wire that policy makers are ready to tighten again if need be and that it's premature to presume the central bank is done restraining credit for the year. He also said Year 2000 computer concerns won't keep the Fed from moving as January 1, 2000, approaches. It doesn't get any clearer than that.
Given Friday's rally, are Treasuries getting too pricey? Jim Kochan of Robert W. Baird & Co. thinks they are "very expensive," as are corporate and agency bonds. Instead, he's advising investors to take a look at municipals and mortgage-backed securities.
Kochan says Treasuries are so costly right now because market participants have become too complacent about the outlook for Fed policy and the risks posed by a higher federal funds rate. As recently as two weeks ago, when the two-year note yield was 5.78%, analysts argued that the market was comfortable owning the securities with the fed funds rate at 5.25%. Yet that argument fell short because of the extremely narrow 50-basis-point spread between two-year yields and fed funds.
During most of the past 12 months, Kochan says, the two-year-to-fed-funds spread fluctuated within between zero and 50 basis points. During the August-to-December period covering Russia's economic meltdown, the spread was negative, reaching -100 basis points during October. This 12-month record may have convinced many market participants that a 50-basis-point spread over fed funds is adequate to compensate them for interest risk over the next two years. But during much of that period, the Fed was easing or expected to hold short-term rates steady. Now that the central bank is tightening, the spread seems too narrow, says Dennis Hynes of R.W. Pressprich. During the last two periods of Fed tightening, in 1994 and 1997, this spread was much greater; it averaged between 100 and 200 basis points in 1994 and roughly 11 basis points in 1997. The two-year-to-fed-funds spread reached 100 basis points in 1999 just prior to the Fed's June rate hike, the first its current tightening cycle. But late last week as investors braced for another one-quarter percentage point tightening this year, the two-year to fed funds spread was a scant 38 basis points.
What makes this discussion timely is that Treasuries may become scarce later in the year because concerns over potential Year 2000 computer glitches may send investors flooding into dollar-denominated assets. Because U.S. financial markets have led the charge toward Y2K readiness, they may be viewed as the safest and most liquid investment arena come January 1, 2000. The fact that the Treasury Department is reducing the supply of government securities won't help things. As a result, few observers expect a return of wide two-year-to-fed-funds spreads. But even in a period of Treasury paydowns and Y2K-related liquidity premiums, Hynes notes, it may be too optimistic to expect the two-year yield to stay below 50 basis points over the 5.25% fed-funds rate. For now, though, investors' willingness to pay up for the most liquid securities-current Treasury issues-is artificially driving prices higher. This dynamic also is making older so-called "off-the-run" Treasuries rather cheap. Yet it should make newer Treasuries even more expensive to the fed-funds rate through yearend. |
