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Fed hikes to continue; labor in short supply; bonds tumble
Simply Economics - October 5, 2018
By Mark Pender, Senior Editor



Jerome Powell wore out his shoes on the speaking tour the past week and the theme is clear -- rate hikes are going to be gradual but they won't be stopping. However transparent the Fed is, continued talk of rising rates may be manifesting itself as a self-fulfilling prophecy in the bond market. And not helping rates is an important factor that has been quietly hiding in the background this year -- the Fed's balance sheet unwinding. But the ultimate reason that rates are climbing, make no mistake about it, is that the nation's labor supply is growing scarce.


The economy

The nation's unemployment rate fell more than expected in September, down 2 tenths to 3.7 percent which is a 49-year low. Though unexpected, the sharp dip really shouldn't be any surprise since unemployment claims hit 50-year lows during the report's mid-month sample week. The key here is the drop underway in the number of people who are actively looking for work, at only 5.964 million in September for the lowest total since December 2000 as seen in the accompanying graph. What's especially important is the relationship with the number of job openings which keeps going up, to 6.939 million in the latest available data which is for July. Labor, especially "quality labor" as Jerome Powell notes, is in short supply. The lack of candidates however qualified not only limits the ability of businesses to expand their markets but it also raises the risk that businesses will begin bidding up wages to pull existing workers from their competitors.


But despite all the demand for labor, wages really aren't showing much traction at all in what seems to contradict the law of supply and demand. A key measurement of wages is average hourly earnings in the employment report which is the red line in the graph, at a year-on-year 2.8 percent which isn't much above the blue line of core consumer inflation. And if we include food and energy, the CPI is up 2.7 percent which nearly matches average hourly earnings. Powell said it's a "mystery" why strong demand for labor has not given a lift to wages, but he is confident that, despite the rise underway in job openings, there is no immediate danger wages will move high enough or fast enough to affect overall price inflation. Like many, Powell suspects that globalization, which allows employers to tap into a wider workforce, may be behind the lack of worker bargaining power.


Another of the week's key numbers is the nation's trade deficit which, after sharp improvement earlier in the year, has deteriorated noticeably. Whether tariff-related effects are in play right now is uncertain. What is certain, at least for GDP, is that the deficit is deepening, to $53.2 billion in August with July at $50.0 billion. This compares with a monthly average of $44.6 billion in the second quarter which spells big trouble for net exports in the third-quarter GDP report. Exports are unfortunately moving in reverse, falling 0.8 percent in August after a 1.0 percent drop in July. The export of services, which is the nation's strength and which seems to be dodging any trade-war fire, rose 0.3 percent to $70.5 billion in August. Exports of goods, in contrast, fell 1.4 percent to $138.9 billion following a plunge of 1.6 percent in July. The weakness in goods is centered in agricultural products, down $1.2 billion in August to $12.0 billion with industrial supplies also noticeably weak, down $2.4 billion to $44.1 billion. Turning to the other side of the report, imports rose a deficit-deepening 0.6 percent with the increase centered in vehicles which climbed $1.0 billion in August to $31.7 billion. Imported consumer goods, which are the nation's big trouble spot, rose $0.9 billion to $53.5 billion. Country data show a deepening imbalance with China, at $38.6 billion vs July's $36.8 billion, and a widening with Mexico to $8.7 billion vs $5.5 billion in July. The deficit with Canada narrowed noticeably to $2.7 billion as did the deficit with the EU to $15.7 billion. The deficit with Japan, which hasn't been getting much press at least yet, deepened sharply in the month to $6.0 billion from August's $5.5 billion.


A highlight of the coming week, or rather a likely low light, will be the Treasury's budget statement for September which will close the government's 2018 fiscal year, and a very dismal one at that. Eleven months into the fiscal year the deficit, at $898 billion, was running 33.3 percent deeper than fiscal year 2017. But Jerome Powell, who unlike Alan Greenspan especially, isn't complaining about the deficit, not wanting any more confrontation with the Trump administration. Yet Powell is on record with the obvious, that the nation's budget deficit is unsustainable. A nearly 7 percent rise underway in defense spending is a major reason for the deepening but Powell isn't focused on this, instead citing Medicare costs which are nearly as large as defense and are running at an 8 percent rate. And what about the spending side? Are voodoo economics, or I mean "dynamic scoring", working? Is the tax cut actually raising tax revenue? Yes is the simple answer as individual tax receipts are rising at a 7 percent clip and at $1.522 trillion in the fiscal year to August were up an even $100 billion from the same time last year. But the tax cut on the corporate side isn't having the same effect. Here receipts are running 30 percent below last year and at $163 billion are down $71 billion. The net $29 billion gain in total tax receipts isn't making much of a dent in the deficit, not when total government spending is approaching $4 trillion. For September's data, which are scheduled for release on Thursday, forecasters see a $62 billion surplus that would trim the full year red ink to $836 billion in what would be a still very steep 25 percent deepening from $666 billion in fiscal year 2017.


Making a big splash in the past week was a report that rarely makes waves, the Institute for Supply Management's non-manufacturing survey. Jumping to 61.6, the index, tracked in the blue line, easily beat Econoday's consensus range for the strongest reading on record. The index is a composite and was established in 2008 but components in the report go back another nine years. The business activity index surged to 65.2 for a new record with new orders also rising and delivery times lengthening and all adding to the composite index. Also adding was a record high in employment, surging to 62.4 in what did perhaps correctly signal the decline in September's unemployment rate but definitely not the month's relative lack of payroll growth, at a lower-than-expected 134,000. But this isn't the only inconsistency as the rival PMI services index, published by Markit Economics, went in the other direction in September, falling to 53.5 for an 8-month low. The weakness in this survey is tied to an easing in optimism on rising costs and also trouble in the housing sector which we'll get to in a moment. Both surveys use the same methodology and, though neither provides exact totals, they have roughly the same sample size -- which is small, perhaps numbering a couple of hundred or so. But again, this is an important detail that is never provided. One difference that's giving ISM's data a comparative lift is the inclusion of the mining and construction sectors which have had good years, especially the former.


Construction spending was one of the week's disappointments, managing only a 0.1 percent gain in August following only a 0.2 percent gain in July and a 0.7 percent decline in June. But year-on-year growth, as tracked in the blue line, is up a very healthy 6.5 percent and of course is helping to give a lift to construction payrolls which are up 4.5 percent on the year. Growth in payrolls could very well be higher if not for shortages of construction labor which have been cited not only in the ISM non-manufacturing survey but also in the Federal Reserve's Beige Book of economic conditions, the latter cited frequently by Powell and offered as a justification for the Fed's rate-hike sequence. Turning back to spending, the increase is being fed by a 14.0 percent rise in public spending (both Federal and state & local) that is offset by a smaller 4.4 percent increase in private construction spending, split here between a solid 5.3 percent rise for nonresidential and a respectable 4.0 percent gain on the residential side. But housing in general, including home sales, have been flat this year and won't be getting much of a lift from the week's big news in the financial markets -- the sharp rise underway in interest rates.


Markets: Scary shift higher, rates frighten

The gigantic rise in the 10-year Treasury, up 18 basis points to 3.24 percent, was the week's big news not only for the financial markets but also for the economy. The rise will lift long-term borrowing costs and won't be giving residential investment, which is really the economy's slowest area, any lift. If there's any question how closely mortgage rates track long-term Treasury yields the accompanying graph provides the answer. The average rate for nonjumbo 30-year fixed mortgages is already near 5 percent and looks with certainty to be going higher. But what isn't certain is why the 10-year Treasury sold off so steeply in the week. The move started Wednesday morning following a strong ADP employment estimate and picked up steam following the ISM non-manufacturing report, but the way the selling gathered momentum hints perhaps at technical factors within the bond market. One of these factors could very well be the Fed's quantitative tightening as Treasury holdings in its balance sheet fell a very sharp $19.0 billion in the week ending Wednesday. The Fed's holdings of mortgage-backed securities were unchanged in the week but unwinding here is behind schedule and an accelerating MBS run-off going into year end will be another negative for both the bond and mortgage markets.


The 10-year wasn't the only yield going up in the week as the 2-year rose 8 basis points to 2.88 percent. This rate tracks the Fed Funds target which was raised 25 basis points in the prior week to 2.125 percent and, based on  FOMC projections, will be rising another 100 basis points over the next year as tracked by the red line at the right of the graph. The rise in short-term rates may have limited impact on the housing market but will nevertheless increase borrowing costs for consumers and businesses. The week's rise in yields gave the dollar a lift, climbing 0.5 percent on the dollar index to 95.62, and cut the legs off a stock market rally early in the week. The Dow ended fractionally lower on the week at 26,447.


Markets at a Glance Year-End Week Ended Week Ended Year-To-Date Weekly
2017 28-Sep-18 5-Oct-18 Change Change
DJIA 24,719.22 26,458.31 26,447.05 7.0% 0.0%
S&P 500 2,673.61 2,913.98 2,885.57 7.9% -1.0%
Nasdaq Composite 6,903.39 8,046.35 7,788.45 12.8% -3.2%
Crude Oil, WTI ($/barrel) $60.15 $73.46 $74.31 23.5% 1.2%
Gold (COMEX) ($/ounce) $1,305.50 $1,195.40 $1,207.10 -7.5% 1.0%
Fed Funds Target 1.25 to 1.50% 2.00 to 2.25% 2.00 to 2.25% 75 bp 0 bp
2-Year Treasury Yield 1.89% 2.80% 2.88% 89 bp 8 bp
10-Year Treasury Yield 2.41% 3.06% 3.24% 83 bp 18 bp
Dollar Index 92.29 95.15 95.62 3.6% 0.5%


The bottom line

The sell-off is scary for bonds, a market that traditionally defines the playing field for other securities including equities. And the move does swing the spotlight on the Fed's balance sheet unwinding. Yes the week's economic news was good but against the backdrop of rising rates, the question has to be asked whether we'll look back at September's 3.7 percent unemployment rate as the peak of the economic cycle.


Week of October 8 to October 12

September's first inflation reading is in the books with the moderate 0.3 percent showing for average hourly earnings. Now in the coming week, the rest of the month's price news will be posted. Pressure in producer prices proved non-existent in August and for September's report on Wednesday, expectations are likewise subdued. Consumer prices for September will be posted on Thursday and here too forecasters are not looking for any significant pressure. Import and export prices follow on Friday in data, reflecting price weakness on a global scale, that have been the softest of any of the inflation reports. October updates on inflation expectations, one of Jerome Powell's favorite topics, will also highlight the week, first on Wednesday with business expectations from the Atlanta Fed then on Friday with consumer expectations in the consumer sentiment report. Other data to watch will be the Treasury Budget for September which finalize the total of the government's very steep deficit in fiscal 2018. Note that the budget data are scheduled for Thursday afternoon though delays and postponements are common for the fiscal year-end report.




Small Business Optimism Index for September

Consensus Forecast: 108.0

Consensus Range: 107.0 to 109.2


The small business optimism index is expected to ease slightly to 108.0 in September vs August's 108.8 which was a new record in 45 years of data. Plans to build inventories gave August a special boost with rising plans for capital outlays and hiring further pluses.




PPI-FD for September

Consensus Forecast, Month-to-Month Change: 0.2%

Consensus Range: 0.0% to 0.5%


PPI-FD Less Food & Energy

Consensus Forecast, Month-to-Month Change: 0.2%

Consensus Range: 0.1% to 0.3%


PPI-FD Less Food, Energy, & Trade Services

Consensus Forecast, Month-to-Month Change: 0.2%

Consensus Range: 0.2% to 0.3%


Despite elevated input costs through most manufacturing reports, producer prices have been subdued. Following August's 0.1 percent decline, a rise of only 0.2 percent is expected for the September producer price headline. When excluding food and energy, prices are expected to also rise 0.2 percent as they are when also excluding food, energy and trade services.


Wholesale Inventories for August

Consensus Forecast, Month-to-Month Change: 0.8%

Consensus Range: 0.7% to 0.8%


Wholesale inventories, which have been lean relative to sales, are expected to rise a very sharp 0.8 percent in August, unchanged from the month's advance reading.




Consumer Price Index for September

Consensus Forecast, Month-to-Month Change: 0.2%

Consensus Range: 0.1% to 0.3%


Consumer Price Index

Consensus Forecast, Year-on-Year Change: 2.4%

Consensus Range: 2.4% to 2.7%


CPI Core, Less Food & Energy

Consensus Forecast, Month-to-Month Change: 0.2%

Consensus Range: 0.1% to 0.3%


CPI Core, Less Food & Energy

Consensus Forecast, Year-on-Year Change: 2.3%

Consensus Range: 2.2% to 2.4%


Only modest pressure is what forecasters see for September's consumer price index, at a consensus increase of 0.2 percent which would match the rise in August which was held down by a contraction in medical costs and apparel. The consensus for the ex-food ex-energy core rate is also 0.2 percent vs August's marginal 0.1 percent increase. Year-on-year rates for September are seen at 2.4 percent overall, vs 2.7 percent in August, and 2.3 percent for the core vs August's 2.2 percent.


Initial Jobless Claims for October 6 week

Consensus Forecast: 210,000

Consensus Range: 200,000 to 210,000


Initial jobless claims are expected to come in at 210,000 in the October 6 week vs a lower-than-expected 207,000 in the prior week. Hurricane Florence and related flooding in the Carolinas turned out to have no significant effect with increases in North and South Carolina proving limited.


Treasury Budget for September

Consensus Forecast: $62.0 billion

Consensus Range: $57.0 billion to $93.0 billion


Individual tax receipts are up, corporate tax receipts are down and spending on Medicare and defense is on the rise. Eleven months into the government's fiscal year, the year-to-date deficit to August, at $898.1 billion, was 33 percent deeper than the prior year. Econoday's consensus for the September Treasury statement is a monthly surplus of $62.0 billion.




Import Prices for September

Consensus Forecast, Month-to-Month Change: 0.2%

Consensus Range: 0.0% to 0.5%


Export Prices

Consensus Forecast, Month-to-Month Change: 0.3%

Consensus Range: -0.2% to 0.3%


Dollar strength along with subdued inflation at the global level have been pulling import prices down. Forecasters see September import prices rising only 0.2 percent following declines of 0.6 percent and 0.1 percent in the two prior months. Export prices have also been weak, falling 0.1 percent and 0.5 percent in the last two reports with a 0.3 percent increase the call for September.


Consumer Sentiment Index, Preliminary October

Consensus Forecast: 99.0

Consensus Range: 97.5 to 102.0 


Expected to ease from the September score of 100.8, Econoday's consensus for the preliminary consumer sentiment index for October is expected to come in at 99.0. The September report proved the strongest since March, reversing softening in prior months on rising assessments of both current conditions and expectations.


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