Friday, September 01, 2006

Employment Takes The Fed Out, Business Week Takes Out Housing

After dipping a bit in April and May, nonfarm employment added 128,000 seasonally adjusted workers. As key as this number is, remember Poole told us yesterday that it isn't one data point, June was revised up from 124,000 to 134,000 and July was raised to 121,000 from 113,000. August's employment number is also the three and the six month average. Right on target, as the Fed told us in early June, for trend growth at this level of resource utilization. A non-inflationary growth path if there ever was one.

The impact of this number means that Sep is officially off the boards (as if there ever should have been any doubt) and now Oct is wiped off as well. My reasoning is that the Fed, once again as Poole told us, reacts to strings of data that paint a story in line with other data. The data the Fed is most sensitive to is employment -- after all, that is one of their two missions. No matter what the Sep data show in October, it is not going to cause the Fed to react. I leave out, of course, the unforeseen random event that could crater the economy.

In the past few trading days, however, the market has been pushing up the odds of an ease. After the data came out, there was a brief selloff that was effectively pulling those odds back to zero. But neither is the market to be daunted by one data point. So when the 7% drop in pending homes drop (month-over-month) came out, the market rallied the ease scenario back into the price structure for 2007. In creating this outlook for weak growth based on weak housing, the market obviously discounts the 17,000 construction jobs added in August v 5,000 in July and after shedding 6,000 in May and June combined. Perhaps Poole was right in his q&a yesterday when he noted that other areas of construction, namely nonresidential, was fine and there is an overblown importance given to housing.

Based on inter-month spreads in the Federal funds futures contracts, the market is pricing in an approximate 30% chance of the Fed easing in January. From now to year end, the market is giving about a 60% chance that the Fed does nothing and thus a 40% chance, equally divided, that the Fed does something. Right where the Fed wants us -- smack in the middle recognizing the equal probability of an ease or a tightening.

When the Fed-speakers address current market expectations, I believe they are talking about the ease priced in for next year. By my calculations, the market is giving 50/50 odds that the Fed will cumulatively drop the funds rate 100 basis points in 2007. The market has kept this view even though employment is rising apace, income is up, gas prices are down, and the dollar is weaker (helps capex. The only reason I can surmise is the singular focus on housing. Not just the knock-off effect of reduced construction and rising inventories of unsold homes, but also the ticking time bomb of the impact of rising rates and falling home prices on various exotic mortgages.

This week Business Week has the following cover story:

Now we can rest assured that everything is fine. Will all due respect to the hard working folk at Business Week, their covers have been a contratrend indicator for years.

I still hold that the biggest risk in the fixed-income market is the stubborn view that the economy will slow and the Fed will ease. Perhaps with the end of summer, cooler temperatures will bring about more rational reasoning.

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