BlackRock on last week’s US jobs report

The strong employment report went a long way toward dispelling prior disappointment, and we think it should keep the Fed’s policy normalization path on track.

Labor Market Continues to Display Strength, Fed Policy Evolves, Yet Eyes Must Remain on Other Central Banks
Last month we argued that while headline payrolls figures had disappointed somewhat, when judged in the proper context, the labor market recovery still appeared firmly on track, and this month we seem to have reversed the disappointment. Indeed, the headline nonfarm payroll print for June came in at 222,000 jobs gained for the month, with a solid 47,000 jobs added due to revisions to the months of April and May. As a result, the 3-month, 6-month, and 12-month payroll moving averages at 194,000, 180,000 and 187,000, respectively, were well in line with 2016’s strong employment gains. Further, the unemployment rate ended a string of declines thus far this year, ticking up last month, to 4.356% on an unrounded basis, and we think continued labor market strength will allow the rate to march even lower by year end. To put this data in context, since 1970, or for virtually the past 50 years, the U.S. economy has had less than a 4.3% unemployment rate for only 4.0% of the time, with virtually all of that between 1999 and 2001, so this underscores the strength of the current recovery.

In our view, the employment report always carries a significant meaning in terms of assessing the true underlying demand for labor, the price of that labor, and the average workload of the workforce (average hours worked). It also, almost always, lends itself to significantly greater clarity on the attainment of the Federal Reserve’s dual mandate objectives of full employment and price stability. In that light, we would argue that the report signaled a strong indication that the Fed will be able to continue on its rate normalization process, given the continued proximity to full employment (which presumably resides near the low-4% range, but could possibly be as low as the mid-3% range, in terms of unemployment rate), and what is in our view, close to mandated price stability.

While we recognize that there has been a lag in the normal trajectory of higher wages alongside full employment (average hourly earnings increased at a 2.5% year-over-year rate in June); wage acceleration (and consequently higher inflationary expectations) is well within the tolerances that the Fed has laid out to continue executing on its normalization process. We have previously shown that there are very good reasons why the normal Phillips curve reaction to low unemployment is likely to lag in this economic cycle, with an ultimately lower reaction function than historically has been witnessed. Some of the factors accounting for this difference are: just-in-time hiring, technology-driven job efficiencies, a lower goods-producing (high wage) workforce, and a rapid growth of temporary hiring (which is to say, more permanently temporary employees).

Thus, we think that the Fed will see this wage data as satisfactory and clearly can execute a September decision (and quick implementation) on initiating balance-sheet reduction. The Fed’s process of reducing the size of its balance sheet should be viewed as unwavering until the balance sheet is closer to something like $3.0 trillion, from the existing $4.3 trillion level. This also allows the Fed a good deal more time to decide on a December rate hike after having begun its balance sheet reduction program. That said, we think that the rates fireworks has gone well beyond merely looking at what the Fed does. We think that longer-term interest rates now pivot more off of international rate policy, such as that stemming from the European Central Bank and the Bank of Japan, and not solely on what the Fed is doing. Thus the communication from these other central banks warrants close attention from investors.

The BOJ will be very deliberate from here in terms of moving rates, but ECB president Draghi has recently made two ground-breaking statements that are likely to influence policy perceptions in Europe, namely that: 1) deflationary risks have turned into inflationary risks, and that 2) fiscal headwinds have now turned into tailwinds. These policy pronouncements (which also at least point to the reduced left tail risks to the region’s economy stemming from the French election), are shifting the global longer-term interest rate paradigm, and are now not only driving nominal, but particularly real rates, in the U.S. to tangibly higher levels. In fact, we think this elevation in rates is likely to be sustained, and indeed, we may approach 2.50% to 2.75% 10-Year Treasury rates by the end of 2017. To clarify, we do not believe rates are headed continually higher, but rather that we are stair-stepping higher to a new range for rates, as real rates have been held artificially too low and now can normalize another 25 to 50 basis points higher in 2017. Clearly, this path to a higher range will not resemble a straight line, but all eyes must now not only focus on the Fed, but also vitally on the ECB and the BOJ, as we continue to see the economy (and policy) evolve and recover this cycle.

Rick Rieder – Chief Investment Officer of Fundamental Fixed Income – BlackRock