July Employment & Fed Notes

Well, as you know, there were big market moves and lots of commentary on Friday’s labor report, which came in below expectations. Equities and interest rates both moved sharply lower. Futures markets went from a 90% chance of a 0.25% cut at the Fed’s September meeting to an 80% chance of a 0.5% cut.

I don’t know if there is some detail I missed in the report, or if there has just been a buildup to a vibe shift as a number of indicators have slowly become less positive. Or, if it was a knee-jerk reaction to the Sahm Rule getting triggered.

Preston Mui at Employ America has a thorough review of the report. I think the Employ America position is that the report wasn’t a major disappointment, but that it is time to cut the Fed rate.

Parker Ross has a lot of interesting things to say. I’d say he’s a bit more in the recessionary worries camp. Generally, the sentiment seems to be that the bottom’s not falling out, but we have been slowly moving into bad territory and may be hitting a tipping point where nominal stimulus is clearly prudent.

Employment Flows

Figure 1 from Matthew Klein makes a good case that the headline numbers this month were worse than the true underlying condition. Most of the rise in unemployment was temporary and maybe weather related or from growth in the labor force. These are not flows associated with a deteriorating business cycle.

And, the rise in unemployed entrants to the labor force was, on net, due to fewer unemployed workers leaving the labor force this month. That is especially not a flow related to a deteriorating cycle.

Another flow that doesn’t have any obvious cyclical signal is the number of unemployed workers who remained unemployed. That is moving sideways. And, both the mean and median number of weeks of unemployment duration have remained pretty flat.

But there appears to be some bifurcation in the labor market, because unemployment over 15 weeks has been rising. Shown in Figure 2, this is a measure that is giving the first hints of a recession signal that has been pretty dependable in the past. Though, what is odd here is that this is usually more of a lagging recession indicator.

Inflation Expectations

Figure 3 shows the change in the expected inflation rate today. That seems a bit much. A 0.2% decline in the 5 year expected annual inflation rate and 0.15% in the 5 year forward expected annual rate.

The Yield Curve

The yield curve really changed this week. Fed rate cuts are suddenly expected to come faster and steeper. The bottom is now expected to be about 3% - a full 1% lower than it was just a couple months ago.

The recent yield curve has been odd. People applying standard yield curve measures without understanding the peculiarity of the current cycle have been calling it inverted. It hasn’t been inverted.

Back at my old blog in the 2010s, I argued that the zero lower bound distorts the yield curve, and that when interest rates are very low, the yield curve is functionally inverted even if it has a slight upslope. In other words, if it was truly inverted, I would be among the first to call it that. It was inverted in early 2022 when real growth turned negative (Figure 4 right panel). It steepened because we don’t deserve JPow! and he held off on rate hikes long enough for economic sentiment to improve, and the yield curve steepened.

You can see in the right panel of Figure 4 that the yield curve steepened before the Fed started hiking the short term rate. The Fed chased the yield curve up in 2022. JPow! is a winner. As I have frequently discussed here, Fed rate hikes didn’t bring inflation down. Inflation was transitory and the Fed was blessedly patient about it. The Fed followed real rates up.

You can see in the left panel of Figure 4 that there is a bump at the short end of the curve, but that the long end in the out years has remained upward sloped. It had gotten a little flattish in May of this year. It has actually steepened since then. It even steepened more on Friday. I would call that bullish.

I have been more dovish than the Fed for some time. Mostly because I don’t think rent inflation should be included in the inflation index that the Fed uses to guide their policy. And, when you exclude rent from the indexes, inflation has been roughly 2% since July 2022.

I suspect that the Fed has more room to fudge than normal. Housing construction is typically a leading indicator. But, construction is still stuck at capacity because of remaining Covid dislocations. The oddly high very short term rates would normally affect construction loan activity and slow down housing starts. But, there is so much pent up demand for housing and capacity is still so constrained that builders still have a backlog of projects. The Fed can’t really slow down or speed up housing completions.

And, if a lower short term rate did stimulate more starts, builders would have just bid up the price of inputs (which are already cyclically high) and added more units to the queue. So, lowering the rate would probably be unusually inflationary.

So, the big bump at the short end of the yield curve may not have mattered much, and it probably has been the case that lowering the rate would have been inflationary.

Figure 5 shows how the yield curve evolved in the run-up to Covid. The curve in 2018 was basically inverted. It will remain an open question whether the Fed was lowering the target rate fast enough to avoid recession if Covid hadn’t interrupted the cycle.

You could say that the yield curve steepened as the Fed cut the target rate in 2019. In fact, the evolution of the yield curve in 2019 was similar to how it has evolved in the last couple of months. So there are two questions. Was the evolution of the yield curve in 2019 recessionary? And, is the yield curve today following the same path?

I would consider it bullish for the long end of the yield curve to stay high. I don’t think we want it to be steep because the Fed chases a declining natural rate down. We want the whole yield curve to stay high and especially the long end, reflecting a positive sentiment.

This is why I find the public comments of macroeconomists puzzling. Scott Sumner has good comments on this. He pointed out that Richard Clarida, a former FOMC member, reacted to Friday’s falling rates with something like “The bond market is doing the Fed’s job for it.”

Paul Krugman tweeted on Friday, “A weak jobs report could actually boost stocks by reducing long-term interest rates (as it did).”

As Sumner wrote, “No, no, a thousand times no!!!”

I am not a macroeconomist, so I don’t know the answer to this, but it would appear that macro is taught at the highest levels as if the causation from interest rates is all in one direction. They seem to think it’s just a case of low rates stimulate and high rates don’t.

Yikes.

Upside Down CAPM

The way I would think about interest rates, which I guess isn’t taught anywhere in macro, is that there are two markets for capital.

There is a market for at-risk investments, mostly served by equity markets of various kinds. This is unconventional, I guess, but I think, in practice, the expected returns on those investments are relatively stable. About 7% plus inflation at any given time. But, realized returns are all over the map. This is part of the reason I have come to accept that interest rates aren’t important in housing markets. First, I came to realize that they aren’t important in equity markets. That put me in a state of mind to believe the empirical history.

There is a separate market for deferred consumption, mostly served by fixed income markets that are cleared by interest rates. In those markets, savers want to make sure they get their principal back. They are willing to take a discount for that certainty, so low-risk fixed income pays less than 7% plus inflation.

Fixed income is a service (the service of deferred consumption) provided from the borrower to the lender. The size of the market is determined by the amount of public debt outstanding plus the value of fixed assets that can serve as collateral to guarantee return of principal. The price in this market is determined by economic sentiment. How much of a discount on the return are savers willing to take in order to receive certainty on returns?

Corporate debt outstanding isn’t even very cyclically sensitive. Since it is a service provided by the borrower to the lender, it is remarkably stable as a percentage of corporate net worth, and it has declined in proportion to corporate equity value as corporate value has become less dependent on physical, long-lived assets. The convention seems to be to treat debt as some sort of pro-cyclical use of leverage. That seems both conceptually confused and empirically unfounded to me.

As I have written elsewhere, the largest corporations today are net creditors. Debt has nothing to do with the rise of today’s mega-caps. It’s just one more point where empirical facts seem not to matter at all.

At-risk investment is a service provided by investors to all of us. Those investments create growth. And the return the investors expect to receive comes from that growth. When growth expectations are high, stocks sell at higher price/earnings ratios.

That is because real total expected returns = real expected growth plus current earnings/price, and in practice, real total expected returns are relatively stable. So, when growth expectations are higher, investors are willing to accept a lower yield on earnings today.

High growth expectations cause higher stock prices. Lower interest rates do not. In fact, lower interest rates are associated with more saving and less at-risk investment, and, thus, lower growth.

Economists like Krugman apparently think that these two capital markets are largely complements but they are really more accurately thought of as substitutes. It is hard to me to fathom how conventional macro could treat this core issue with such confusion. But, I don’t see how else to interpret comments like Krugman’s.

Equity prices declined Friday because real growth expectations declined. Interest rates declined Friday because new concerns about equity losses moved capital from an investing sentiment to a principal-protection sentiment.

We want high real long term interest rates, because that means capital is being invested for growth rather than merely saved.

I wish that the Fed used a different model for communicating monetary policy. But, they communicate it through an interest rate target. So, there is a very limited way in which lower rates can signal stimulus. That is if the Fed lowers the target rate enough to push it below the neutral market rate. In order to do that, in theory, they have to inject cash into the banking system.

You can tell when the neutral market rate is moving too fast for the Fed to get ahead of. Rates change without monetary injections. The Fed wasn’t growing the monetary base in late 2007 and early 2008 when they were lowering their target interest rate. They were just chasing the collapsing rate down. That’s bad.

This time, currency and M2 expanded sharply when Covid struck, and growth has slowed as they both have levelled back off toward the long term trend. One thing to look for as the Fed cuts this time is for currency growth to pick back up. If the money supply flat-lines as they lower their target rate, look out below.

By the way, my upside down CAPM approach helps to understand the 2008 crisis. I wrote about this in Building from the Ground Up. The CDO boom and especially the synthetic CDO boom, which were the focus of “The Big Short” and other retrospectives about the crisis, was not part of a bubble.

Low-default fixed-income is a service provided by the borrower to the lender. There was such huge demand for saving (instead of investing) that banks were doing back flips trying to conjure up new securities for all the savers trying to hold on to their principal. Those savers were “reaching for yield” in the parlance of the day. That’s how the confused conventional approach flips reality on its head to pretend that a boom in AAA-rated securities was part of a speculative bubble. The yields were only higher because the risk-free nature of the new securities was on increasingly shaky ground as the number of fearful savers outpaced the availability of truly safe assets.

They had to create CDOs and then synthetic CDOs because they couldn’t find enough investors to take the equity position on either the homes themselves or on the securitized mortgages. Eventually the few remaining equity holders were seen as “dumb money” and their failure was universally seen as a communal victory.

“The Big Short”, even in film form, does an amazing job of both documenting the empirical activities of the time and reflecting (and accepting without judgment) the masochistic interpretation of those activities that made the crisis such a popular outcome.

The next post will go into housing a bit more, for subscribers.