On Friday the US released their much anticipated unemployment figures. They were much better than expected with the Change in Non-farm Payrolls coming in at 288k versus a forecast 218k. The previous month was also revised to 203k from 192k. This is the third month in a row that payrolls met or exceeded expectations:
US Non-Farm Payrolls versus expectations</a> </div>
Unfortunately the payroll gains did not translate into wage growth. The Average Hourly Earnings rose by only 1.9% versus an expected 2.1%. This miss was even worse given that the 2.1% was forecast with a much lower payroll figure. So far the improvements in the labour market are not translating into wage growth.
It is a good thing that Yellen & Co. abandoned their 6.5% unemployment rate threshold for tightening. The unemployment rate for April came in at a blistering 6.3%. This was a huge improvement from last month’s 6.7%.
US Unemployment Rate</a> </div>
The ever prescient Kyle Bass from Hayman Capital Management has been forecasting that the expiration of the unemployment benefits and a continuing lowering of the Labour Force Participation rate, would push the unemployment rate below 6% by this summer. This trend seems to be playing out exactly as predicted with the Labour Force Participation rate falling to a cycle low of 62.8%.
US Labour Force Participation Rate</a> </div>
The improving labour picture creates an interesting dilemma for the Federal Reserve. According to the Taylor Model, the Fed Funds Rate should be set to 1.5%.
Classic Taylor Rule – US economy</a> </div>
There is some debate in the economist community about the various model inputs and constants, but even the adjusted Taylor models are all indicating that the Federal Reserve should be commencing the raising of the Fed Funds rate.
The problem is that the Federal Reserve is no where near ready to raise rates. They have set a schedule of reducing the amount of Quantitative Easing asset purchases by $10 billion per month. It won’t be until the end of the year that the QE program is completely wound down. Given the Fed’s guidance, the first rate hike won’t come until the end of 2014.
If Kyle Bass is correct, we could have a situation where the unemployment rate is plunging to levels that would be indicating a neutral Fed Funds rate that is significantly higher than the current levels.
Most economists seem to be pessimistic about the labour market, but what if they are wrong? Famed strategist David Rosenberg from Gluskin Sheff believes that the labour market is much healthier than most economists are forecasting. He views this recent labour report as just the start of much better reports.
If the labour market does continue to improve (either for Kyle Bass technical reasons or for David Rosenberg fundamental reasons), the Federal Reserve is going to have promised a Fed Funds level for most of 2014 that is excessively too loose. Not only that, Yellen is desperately trying to avoid a repeat of the 1994 bond market rout when the Fed raised rates. She is continuing to emphasize that the Fed will keep rates lower for longer.
I find it ironic that most market participants acknowledge that the economic problems of the 2000s were made all the worse by a Federal Reserve that left rates too low for too long. Yet here we are in the midst of making the exact same mistake again but there is precious few that are calling for the Fed to immediately raise rates.
Not only is the Federal Reserve no where near raising rates, but they are still buying $45 billion of securities every month! This, at a time when the Fed Funds rate should be rising, yet it is glued to 0%.
It will be extremely interesting to see if the Federal Reserve can maintain the bond market’s confidence. So far, they have managed to convince the market that the QE wind down and the rate tightening cycle will go smoothly.
The recent collapse of the spread between the US 5/30 Treasury yield is an indication that the market is not worried about the Fed losing control of the long end of the curve.
US 5/30 Year Treasury Spread</a> </div>
Investors are assuming that the Fed will raise rates sufficiently to keep inflation in check. In fact, their primary concern seems to be the Fed raising rates too quickly and snuffing out the economic recovery.
The market’s faith in the Fed’s ability to control this grand monetary experiment is puzzling to me. Given the Fed’s bloated balance sheet, the massively indebted government and the fragile consumer, does the market seriously believe that the Fed is ever going to be in front of the curve in terms of raising rates?
The much more probable outcome is that the Fed is going to reluctantly raise rates as the market forces their hand. But they will drag their feet. The Fed will only half heartily follow rates higher.
Once the market realizes this, the curve will get extremely steep. We will also have all the ingredients necessary for an accelerating inflation rate. Yet today the market is still optimistic that the Fed will not let inflation get out of control.
I think their chances of being able to manage this QE withdrawal and rate hike in the midst of an improving economy is extremely low. Right now the market has faith. But I wonder for how long?
My steepener trade is not working, but I am not giving up. My plan was to add to the 5/30 spread in the 160s. On Friday we broke below 170. I am not going to add to it yet, but I am watching it closely.
The market is hammering the belly of the curve – mistakenly assuming the Fed will normalize policy much more quickly than is realistic.
What I really would like to be able to hedge
In this day and age of instant information, it is easy to get bombarded with a million different things to worry about. This is also true for the financial industry. There is no shortage of different sites that highlight all the terrible things that are going to take down the financial system.
Although I am often bearish, I would label myself more of a skeptic than a doomsdayer.
“No, Donny, these men are nihilists, there’s nothing to be afraid of.”</a> </div></p>
Over the long run, I am quite bullish on the ability of humanity to progress – I just think that financial markets are often prone to overstating the rewards and the chances of success. I certainly would not put myself in the camp of the “guns and ammo” crowd that think the financial system is about to come to a crashing end.
But there is one thing that scares me and it probably does not get the attention it deserves.
Given the prevalence of global travel, I am petrified that one of these days there will be an Ebola or HIV type virus that quickly spreads.
We have become so reliant on just in time inventory and global trade that any sort of world wide epidemic would have catastrophic consequences on our economy.
I realize that it is a low probability event, but the damage would be so severe that is extremely difficult to even begin to comprehend.
Terrorism is a terrible scourge on society, but it would pale in contrast to a modern day Spanish flu type epidemic.
Therefore my antennae rises when I see reports of nasty viruses started to sprout up.
Recently CNN reported:
The first U.S.. case of MERS-CoV has been reported in Indiana, the Centers for Disease Control and Prevention said Friday. MERS-CoV, short for Middle East Respiratory Syndrome, is a type of coronavirus. Since the first documented cases in spring 2012, MERS has sickened at least 339 people in Saudi Arabia alone and killed nearly a third of them, according to the country’s Ministry of Health.
MERS is a deadly virus that is fatal in about a third of the cases:
(CNN) – MERS-CoV, short for Middle East Respiratory Syndrome coronavirus, first surfaced in Saudi Arabia in spring 2012.
So far, 262 cases of MERS have been confirmed in 12 countries, including the first U.S. case, announced Friday, health officials said. Egypt also reported its first MERS case on April 26, according to the World Health organization.
And it is not only MERS that is making headlines. Recently Ebola returned to the forefront:
Outbreak in Guinea and Liberia. There are at least 208 confirmed or suspected cases of EVD in Guinea, resulting in 136 deaths there, and in Liberia, there are 34 suspected or confirmed cases, resulting in six deaths.
I have no idea about the chances of either of these viruses springing out of control.
However I do suspect that sometime in my lifetime there will be an epidemic that challenges modern society in ways that we cannot even imagine. In the grand scheme of things, high debt levels or overvalued currencies are all just minor problems that can be fixed over time. A global epidemic is an actual disaster that would prove extremely challenging for society. It is the thing that I worry about most but that I have the least ability to hedge…