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Why today's action is significant

From a macro perspective, here are charts of the three most important movers today.

To begin with, yields on Dec. '10 eurodollar futures rose 17 bps, as their price fell by an equal amount. That means the market raised its expectation of where the Fed funds rate will be at the end of next year by that much. Alternatively, you could say that the market accelerated its expected timetable for Fed tightening to begin. Either way, it means that the market interpreted the jobs data as evidence of a stronger-than-expected economy, and that in turn calls for the Fed to begin to reverse its liquidity injections sooner than expected.

Gold prices fell by about 4%. Just two days ago I cautioned that gold was approaching levels that made it highly vulnerable to any sign that the economy was stronger than expected. Bingo, here's the proof. The jobs data was definitely stronger than expected, and that in turn means that the Fed is much less likely to continue to be super-accommodative for a long time. It is thus no longer easy to be long gold. To be comfortable buying gold at these levels you have to be real sure that the Fed is going to make a massive inflation mistake. Thoughts along these lines likely forced the weak longs to cover.

The dollar jumped by 1.4%, because the rationale for selling the dollar (the Fed will keep rates at zero forever because the economy will be hopelessly weak forever, so you can sell the dollar with impunity) was seriously challenged today. The economy is doing better than expected and improving significantly on the margin. The Fed therefore looks to have been way to pessimistic about the economy's prospects, and the market takes its cue from the Fed. As a result, the market realized it had gone too far with the dollar "carry trade."

It's not clear whether today's action marks a clear turning point for these three variables, but I do think it marks at least the beginning of the end of the long gold and short dollar trades. The Fed is not going to tighten anytime soon, unless we see more good news that challenges the still-prevailing consensus that the U.S. economy is a basket case; undoubtedly there will be opportunities for gold to resume its rise and for the dollar to resume its fall in the next few months. But I think we have seen an important inflection point today. Buying gold and selling the dollar are no longer one-way, no-risk trades. They are highly speculative trades, and they depend heavily on the economy remaining weak and the Fed remaining on hold.

Another V-sign

Here's yet another update to this chart I've shown many times. This chart shows the ratio of weekly unemployment claims to the total number of jobs according to the establishment survey. The improvement in this ratio is at least as dramatic as what we saw in the V-shaped recovery following the 1981-82 recession, and much more dramatic than the recovery following the 2001 recession which was generally regarded as very mild, almost U-shaped.

The employment situation is definitely improving

Today's November jobs report arguably marks a turning point in the market's perception of reality. Revisions to previous months added 159,000 jobs according to the establishment survey; when combined with the loss of only 11,000 jobs in November, the economy (presumably, if you trust the government's data) has 148,000 more jobs today than it did a month ago. The household survey says the same thing: it showed a net gain of 110,000 jobs in November, with 39,000 of those coming from the private sector. However, you look at it, there is little doubt now that there has been a significant improvement in the labor market in recent months. 

The market so far has reacted in predictable fashion to the news that the economy was in better shape than previously thought. The dollar is up, gold is down, and expectations of future Fed tightening have been accelerated (the yield on Dec. '10 eurodollar futures is up 17 bps today). Stocks are up, but not by a lot, suggesting the market is cheered by the good news, but at the same time worried that an earlier removal of monetary stimulus might threaten the recovery. I think this latter concern is silly. If the economy grows by any decent amount (3-4% real growth, as continues to be likely in my view), then the Fed must raise rates, and higher rates will only reinforce the recovery because they will restore confidence in the dollar. Plus, as I've mentioned before, the household sector is a net beneficiary of higher rates because households have more floating rate assets than floating rate debt.

I'm watching the relationship of the dollar and equities very closely. To date, they have moved inversely, but today could mark the end of that relationship. If so, we could be embarking on a new era of virtuous trends: a stronger dollar, a stronger economy, and a stronger equity market. It's too early to make that call, but it would sure be something if it were to happen. It would go almost completely against the prevailing wisdom, and that is when exciting things happen from the perspective of contrarians like me.

UPDATE: Here's a chart of the 6-mo. annualized rate of change of private sector jobs, according to the establishment survey. Note the dramatic improvement in recent months.

Commodities update

This chart shows the average price of "raw industrial" commodities, and it doesn't include most of the commodities that you might associate with speculative activities. As of yesterday, the index was only 10% below its all-time high which was set in May '08. This represents a pretty dramatic recovery for commodity prices, especially considering the fact that the U.S. economy, which represents about 20% of global GDP (according to the World Bank) and is roughly twice as large as its nearest competitor (China), is operating with significant excess capacity and is substantially below its full-employment output level.

The strength of commodity prices also stands out when you consider that a) the market cap of the global stock market is 26% below its high of late 2008, b) crude oil prices are about half what they were in mid-2008, and c) the dollar relative to other major currencies is stronger today than it was in mid-2008 and about the same as it was in late 2008.

My point with this is that commodity prices are telling us that something quite significant is going on under the surface of the US and global economies. Strong price action likely reflects both a strong revival in demand as well as the impact of monetary policy which is almost universally accommodative. Whatever the case, commodities are emphatically signaling that the world is in much better shape (both from a demand perspective, and from the standpoint of deflation risk) than markets seem willing to believe.

Commodity price action was one of the early indicators of economic recovery, and the message of commodities has only gotten stronger.

Has Gibbs seen tomorrow's unemployment report?

Lots of speculation today, triggered by White House Press Secretary Gibbs' remark that the unemployment rate might "tick up" tomorrow. Bob Stein, who works with Brian Wesbury now and at Treasury for four years prior, says "I highly doubt the White House has seen the data yet. I think they are just getting in front of a downside possibility, and making an unchanged jobless rate seem like a victory." Check out the link for a full explanation of why it is extremely unlikely that the White House has seen tomorrow's number.

Thoughts on job creation


As the Obama administration holds its jobs summit today, I would like to make a contribution to the debate.

To begin with, consider this chart, which takes the monthly establishment survey of jobs and breaks it down into two components: public sector (federal, state and local) and private sector. Note that the two y-axes are set up so that they both show an equivalent percentage change from bottom to top (12%). Note further that over the past 10 years private sector jobs are down, while public sector jobs are up almost 10%. Public sector jobs rarely shrink (with the exception being census years, when lots of people are hired and then fired); they simply ratchet ever higher. Private sector jobs, however, can drop significantly, as they have in the past two years. The public sector hardly knows the meaning of sacrifice when it comes to jobs, while the private sector ends up bearing virtually the full brunt of every downturn. Note also that at the peak of the last expansion (Dec. '07), the private sector accounted for about 84% of all jobs. Government (fortunately) still plays a relatively minor direct role in total job creation.

But government does play a huge, indirect role in private sector job creation, since most—if not all—recessions are the result of major government policy mistakes: usually erratic monetary policy, and more recently unwise market intervention (e.g., FNMA, FHLMC, affordable housing mandates). Recessions can be also be prolonged by policy mistakes. Extending unemployment benefits reduces the incentives of workers to find jobs; deficit spending absorbs funds that might otherwise be used more productively by the private sector; tax credits can distort economic incentives; high marginal tax rates can reduce the private sector's willingness to take risks; erratic policymaking and government mandates can increase uncertainty about the future and thus reduce the private sector's willingness to hire.

Following the advice of people like Mark Zandi, who yesterday proposed a series of measures supposedly designed to create jobs, and which could cost upwards of $300 billion, would do very little if anything to create jobs. The litany of poor ideas is familiar: extend unemployment insurance benefits, spend more on infrastructure, create a tax credit for hiring, make more money available for small business loans, give more aid to states. It would instead be much better to focus on policies that create new and permanent incentives for the private sector to create jobs: lower corporate tax rates, lower payroll taxes, reduce government mandates, reduce the taxes on capital and dividend income.

We need the government to get out of the way of the private sector, by reducing government jobs,  reducing government regulation and intervention in the markets, and increasing the rewards to work and investment.

UPDATE: Don Boudreaux, a consistent font of economic wisdom, explains why a tax credit for new hires is a bad idea

... (the) proposed tax credit would bias firms toward producing output by using more labor and, hence, would likely increase employment in the short-run.  But the flip side of this effect is that this tax credit would thereby bias firms away from producing output by using more machinery, R&D, and other capital investments.  Because in the long-run workers’ wages are determined by their productivity – and because worker productivity rises with greater, market-driven capital investments – (the) proposed tax credit, by biasing firms away from capital investments, will cause future real wages to be lower than otherwise.

A cut in corporate-profits taxes, in contrast, would simultaneously prompt firms to expand output – and, hence, hire more workers – without biasing firms against making the capital investments that are the indispensable engine of economic prosperity and growth.

The November ISM service sector activity index fell unexpectedly, but my reading of the top chart is that it normally moves in a sawtooth fashion, so this is more noise than it is signal. The same thing, only in reverse, occurred with the service sector prices paid index, which jumped in November. The thrust of both series is unchanged: conditions are improving, and pricing power has returned. The return of pricing power is a stark reminder that deflationary forces are not only in retreat but never had a chance to gain a foothold. Unfortunately, the Fed is still fighting the deflation battle when it could be propping up the dollar instead. Yes, things are far from perfect, but they are nevertheless much better on the margin.

Unemployment claims down by one third

I realize that the big drop in unemployment claims is now old news, but nevertheless it is still impressive and a reminder that the healing forces in the economy are still very much alive and well. Yes, there is a lot of room for improvement, but let's not let the perfect be the enemy of the good. Weekly claims have fallen by one third since the high last March, and today are only 40% above what might be considered "normal." If nothing else, this is hard evidence that there has been some significant improvement on the margin in economic conditions.

For those who are still skeptical of this year's strong advances in equities and corporate bonds, I would note that one year ago the market fully expected that today the economy would be in a deep recession, engulfed by deflationary forces. Last March, when the S&P 500 was 40% lower than it is today, the market upped the ante to include a mega depression and a federal government that would know no limits to its expansion or its appetite for the world's savings. Instead, the economy is now in the early stages of a recovery, a stabilization of the labor market is within sight, and the Obama administration's initiatives are being seriously challenged on several fronts. Changes on the margin are what drive markets, and we have seen a gigantic change for the better over the past year.

Virginia getaway

We just got back from a trip to Falls Church for a family affair, followed by two days at a spectacular retreat in the northern countryside of Virginia. The place was the Goodstone Inn & Estate, located just outside the charming town of Middleburg VA, which is about an hour and a half west of Washington DC. Their website has lots of nice pictures, but I think these that I took are quite nice as well. The cottage in the second photo is the one we stayed in. It's set up for two couples, but we had the whole place to ourselves. Everything about Goodstone was absolutely top-notch, with exquisite attention to detail, superb service, and a delightfully peaceful setting. For $200/night we got the cottage (full kitchen, living room and bedroom) plus a made-to-order breakfast by a professional chef which was as good as any I have ever had. The eggs were impossibly orange (from their own chickens), and the homemade blueberry preserves were to die for. Afternoon tea with fresh-baked cookies, brownies and cheese was also included. In addition, they serve what is probably the best dinner in the entire region 5 nights a week.

Gold update

Gold prices seem to rising at a parabolic rate, which suggests that the market is just a tad bit too bullish. Gold could continue its run, but as we approach the levels (in constant dollar terms) that we saw in 1980, gold becomes extremely vulnerable to anything that could be considered "bad," such as an unexpected Fed tightening or a stronger than expected economy. It's easy to see why gold can continue to rise, since almost all the world's major central banks are extremely accommodative. Plus, gold thrives on the popular view that the future of the U.S. economy lies on shaky ground, and the prospect of trillion dollar deficits for as far as the eye can see is disturbing, to put it mildly.

I'm not trying to argue against gold going higher, but rather that, as we approach the peak levels of 1980 in inflation-adjusted terms, gold becomes very vulnerable to any bad news such as unexpected economic growth or an earlier-than-expected central bank tightening. Gold is now a highly speculative investment, even though the facts strongly support the bullish case. Lots of people are buying the stuff these days, and I'm sure most buyers are figuring they can make a quick buck and protect themselves with a tight stop. Beware the wisdom of crowds.

Job losses continue to slowly decline (2)

I'll say the same thing as last month about this chart. According to the ADP survey, job losses in November were lower than the previous months, but the corresponding job loss number to be released this Friday is likely to be not quite as low as the market is currently expecting (-123K according to Bloomberg). Nevertheless, the important thing is that we are seeing continuing improvement, albeit of the slow variety. This supports the widely held view that the unemployment rate is going to remain uncomfortably high for quite some time—well into next year.

Corporate layoffs have all but vanished (6)

I've been showing this chart since early this year, saying that it was a good indicator of improvement in the economy. Corporate layoff announcements (which are presumably a fairly accurate gauge of distress in the large corporate sector of the economy) are now down to levels that in the past have been consistent with healthy economic growth. The storm has clearly passed. The next shoe to drop will be net new hirings. Earlier this year I called this a "green shoot," and now it's beginning to look like a V-sign. Not quite yet, but potentially, if the next phase for corporate America is new hiring campaigns.

Car sales another V-sign

Several months have passed since the Cash for Clunkers program caused a temporary surge in sales, which was then followed by a slump. The dust has settled, and what we now see is that car sales have jumped 20% since hitting a low last February. We see the same pattern in the Manheim index of used car prices, which has risen 20% since last December's low. These sure look like genuine, V-shaped recoveries to me.

ISM index another V-sign

Although the November reading was a bit lower than October's, the ISM index is still quite consistent with the 3-4% real GDP growth I've been calling for quite many months. This is yet another indicator that we are in a V-shaped recovery, even though 3-4% growth isn't all that strong given how far the economy slumped during the recession. The market continues to be very nervous about growth going forward, but I see no sign of deterioration.

The Aussies have it right

I should be outside enjoying the sun and the beautiful rolling hills, but I thought a tribute to the Aussie central bank was warranted. Today they raised their target rate for the third time in three months, to 3.75%. As a reward for their proactive stance against inflation, and for the fact that they have kept rates much higher than the Fed for quite some time—being more concerned about inflation than the economy—the market has bid up the Aussie dollar to a fairly strong level against the U.S. dollar, as shown in the second chart. Indeed, relative to its purchasing power parity against the U.S. dollar, the Aussie dollar is now as strong as it has ever been. As a side note, over the past three years, commodity prices have risen almost 20% in US dollar terms, but they are flat as far as the Aussie dollar is concerned. This is another way of seeing how dollar weakness in recent years has been due to easy money, with the next shoe to drop being rising inflation.

Blogging will be light

We are in the Virginia countryside at a remote and charming B&B for
the next two days. So bogging will be very light. Maybe some pictures
when I get the chance.

Sent from Scott's iPhone

ClimateGate update

If you believe this, you'll believe anything:

'Leaked emails won't harm UN climate body,' says chairman. Rajendra Pachauri says there is 'virtually no possibility' of a few scientists biasing IPCC's advice, after UAE hacking breach.
 The UN apparently believes that science only operates under its auspices, and that inconvenient facts may be safely ignored.