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Why the modest growth in jobs means an end to QE

The May employment report shed no new light on the state of the labor market. For the past two years, and for the past six months, the private sector has been adding jobs at about a 2% annual pace. Consideriing the huge job losses that came with the Great Recession, that adds up to the slowest recovery in the jobs market in modern times, and it's the source of lots of angst and hand-wringing. Things could be a lot better, but at least jobs are growing. There is no boom or double-dip recession out there, and neither appear likely for the foreseeable future. It's simply modest-to-moderate growth.

But as I've been asserting for a long time, avoiding recession is all that matters when the yield on cash is zero. If the labor market continues to grow at the pace of the past two years, investors who avoid cash are likely to do better than those who hold cash, because the yield on non-cash assets is much higher. Zero-interest cash only pays off if the economy suffers a disruption that reduces cash flow, increases default risk, and/or impairs profits (since any of those is likely to depress the prices of risk assets). As time passes and the economy continues to grow, the cumulative outperformance of non-cash assets will increase the world's temptation to reduce cash holdings, and that will eventually show up as higher prices for risk assets.

The Fed will eventually succeed in reflating the economy, but not by "printing money." Reflation requires convincing the world that holding lots of cash (and relatively safe assets like short-term Treasuries) doesn't make sense. To date, the Fed has been working hard to supply bank reserves to the world in order to satisfy what has proved to be an extraordinary demand for cash and cash equivalents. As the demand for cash declines, the Fed should be able to reverse its Quantitative Easing with no adverse consequences, because it will be trading higher-yielding assets (e.g., notes and bonds) for the cash the public has tired of holding. The key to reversing QE is thus a declining demand for money, and we are seeing the early signs of that in the recent rise in real yields on TIPS and nominal yields on Treasuries (see chart above). Rising yields on relatively safe assets such as 5-yr T-notes and 5-yr TIPS are the flip side of falling prices (i.e., falling demand). Put another way, rising real yields on TIPS are a sign of increased confidence in future economic growth (or decreased pessimism). Increased confidence in the future comes hand in hand with reduced demand for cash and cash equivalents.

But back to the labor market. As the chart above shows, the economy continues to add jobs. Since the low in early 2010, the private sector has created between 6.7 and 6.9 million new jobs, according to the government's two employment surveys. There is no sign that this growth is ebbing or accelerating.

Overall jobs growth has been a bit slower than the growth of private sector jobs, because the public sector has been shedding jobs for the past four years. This is actually a healthy development, since the private sector is generally more efficient than the public sector, and since the public sector had grown like topsy over the past decade or so. A shrinking public sector frees up resources for the more productive private sector, so over time that should boost growth somewhat. We probably haven't seen the end of this shrinkage either.

Private sector jobs growth has been averaging just over 2% a year for more the past two years. This is almost exactly the same pace as jobs growth in the mid-2000s. In a sense, it's business as usual.

The most unusual thing about this recovery is the very slow growth of the labor force over the past four years. Instead of growing about 1% per year (in line with growth in the population), labor force growth has been extremely weak, and has posted only 0.4% growth in the past year. Demographics (e.g., the aging and retirement of baby boomers) can explain some of this slowdown, but it's likely that the large increase in transfer payments since 2008 (e.g., food stamps, social security disability, emergency unemployment benefits) has played a role as well. When compassionate government doles out money to assuage the victims of a recession, it inadvertently acts to retard the recovery because it reduces the incentives to get back to work. It's also likely that the big increase in regulatory burdens in recent years (e.g., Dodd-Frank, Obamacare, EPA rules) has created disincentives for businesses to expand, thus limiting job opportunities and leaving many would-be workers discouraged. Higher marginal tax rates haven't helped either, since they are a disincentive to work and invest. The economy is growing at 2% despite all these headwinds.

Does the Fed really think that buying $85 billion worth or Treasuries and MBS each month and paying for them with bank reserves will change this relatively slow-growth picture? How exactly will more bank reserves lead to more job creation? It's not obvious to me.

As the chart above shows, there is no evidence that the Fed's Quantitative Easing efforts have resulted in any unusual amount of money growth. The M2 measure of the money supply, arguably the best, has grown only slightly faster than 6% per year since the Great Recession. That growth is easily explained by strong money demand: the vast majority of the growth in M2 in the past 4-5 years has come from an increase in bank savings deposits. At the same time, virtually all of the Fed's $2.3 trillion worth of purchases of Treasuries and MBS have gone to support increased currency in circulation and excess reserves. Banks now hold $1.9 trillion of excess reserves at the Fed; they are presumably happy to do so because reserves pay interest and are thus effectively a substitute for T-bills. Banks are still quite risk averse as is the public, since households continue to deleverage. Hardly any of the flood of new bank reserves has been used by banks to increase lending and expand the money supply. Currency in circulation is up more than $0.34 trillion since Q3/08, largely because people all over the world want to hold more dollars under the mattress, so to speak.

This can't go on indefinitely. At some point attitudes toward risk will change, and the demand for safe assets and cash will decline. Bank lending will increase. Money supply growth will increase. Nominal GDP growth will increase. The prices of risk assets will rise further. All of these will be signs that the Fed should begin to reverse QE. As mentioned above, there are already tentative signs of this, and one more non-recessionary jobs report such as today's only makes it more likely that this process is getting underway. I'm reminded of my post last March:

... the biggest risk we all face as a result of the Fed's unprecedented experiment in quantitative easing is the return of confidence and the decline of risk aversion. If there comes a time when banks no longer want to hold trillions of dollars worth of excess bank reserves for whatever reason (e.g., the interest rate the Fed is paying is no longer attractive, or the banks feel comfortable using their reserves to ramp up lending, or the public no longer wants to keep many of trillions of dollars in bank savings deposits), that is when things will get "interesting."

I suspect that the Fed has been engaged in a bit of false advertising, claiming that it is buying billions of Treasuries and MBS in order to lower interest rates and thereby goose the economy. The dirty secret is that monetary policy can't create or stimulate growth, it can only facilitate growth. As I discussed the other day, interest rates are now higher than they were when QE3 started late last year. Paradoxically, rising interest rates are the clearest sign that QE has achieved its real purpose. In reality, all the Fed is doing is satisfying the world's demand for safe assets: exchanging bank reserves for notes and bonds. There's nothing wrong with that, and if they hadn't done this we'd be in a world of hurt—there would have been a shortage of safe money and that could have led to deflation and worse. The Fed has satisfied the world's demand for safe assets, but there is no evidence at all that the Fed's actions have translated into more jobs or faster growth. The economy has been growing all along the old-fashioned way: by adjusting to new realities, by working harder and more efficiently, and by investing more, in spite of all the obstacles. Economic growth and new jobs are not created by adding bank reserves to bank balance sheets.

The issue right now is when the Fed will begin to "taper" its QE program, and whether this will hurt the economy or not. The Fed has suggested that the unemployment rate needs to fall much further before they start to unwind QE, but we're not likely to see a 6.5% unemployment rate anytime soon if current trends continue—it could take another year.

Meanwhile, there seems to be growing unease among FOMC members with the obvious progress the economy is making. It's risky to keep the monetary pedal to the metal year after year when the economy has already demonstrated the ability to create jobs at the same pace as it did in the mid-2000s.

I think this explains why the Fed is trying now to accelerate its transition to an unwinding of QE, well in advance of the economy hitting the targets the Fed had previously proposed. It's a tacit admission that the purpose of QE wasn't really to create more jobs, it was to satisfy the world's demand for safety in uncertain times. Now that the economy has demonstrated the ability to grow for the past four years, and now that the public's demand for safe assets is beginning to decline (witness also the big drop in gold prices in recent months), QE is no longer necessary. Godspeed. It will not be missed. Higher interest rates do not necessarily pose a threat to growth, they are a natural result of growth.

This market correction will pass

Markets appear to have over-reacted to hints that the Fed would taper its QE3 bond purchases sooner than expected. We are still months away from any actual tapering, and at least a year or two away from any meaningful Fed tightening that might threaten the recovery. In the meantime, sensitive and timely indicators show no sign of any deterioration in the economy, and that suggests that risk asset prices are likely to recover.

Seasonally adjusted claims, shown in the chart above, are continuing to decline, down almost 9% from a year ago. On a nonseasonally adjusted basis, the actual number of new claims for unemployment last week fell to its lowest post-recession level, 293K, down almost 10% from a year earlier. No sign here of any deterioration in the labor market, and that in turn strongly suggests that the economy is still growing.

Over the past year, the number of people receiving unemployment compensation has dropped by over 1 million, or about 19%. Since the peak in early 2010, the number has declined by 6.9 million. On the margin, about 750,000 people have dropped off the unemployment rolls in just the past three months. These are very significant changes that increase the likelihood that the economy will continue to expand, because a substantial number of people have an increased incentive to find and accept a new job.

Announced corporate layoffs have been low and relatively stable for almost two years. Businesses are not tightening their belts, and that's another good sign that the economy is still growing.

2-year swap spreads are excellent leading indicators of the health of financial markets and the economy. They remain unusually low, which means markets are very liquid and systemic risk is very low. They show absolutely no sign of any distress that might lead to an economic slowdown.

Credit default swap spreads have jumped in the past few weeks, in line with the correction in equities (and particularly those that are sensitive to rising interest rates), but the magnitude of the jump is not nearly big enough to signal a big problem. The level of spreads continues to reflect a market that is cautious and skeptical, but the increase in spreads on the margin is almost insignificant from an historical perspective.

Similarly, the increase in broader measures of credit spreads in recent weeks is almost imperceptible. Recent developments in credit markets reflect caution, not deterioration.

The above chart of 5-yr real yields on TIPS shows the market's most dramatic reaction to the hints of Fed tapering. Real yields have jumped significantly all across the TIPS curve. But they are no higher today that they were at the beginning of last year. What stands out here is not the recent rise in real yields, but the degree to which real yields had fallen earlier this year. That was a clear sign that the market was worried that the prospects for economic growth were dismal. Real yields now reflect much less concern about the health of the economy going forward. Real yields are still orders of magnitude lower than they would be if monetary policy were tight enough to threaten a recession.

As the chart above shows, the rise in real yields is also telling us that inflation expectations have dropped. But expected inflation is still in line with the norms of the past, and there is no sign here of any deflationary threat that we might expect to see if the Fed were indeed expected to become so tight as to threaten the recovery.

The Vix index (an excellent proxy for the the market's fear and uncertainty) has jumped of late, but from an historical perspective this is only a minor tremor.

Household net worth reaches a new high

According to the latest figures from the Federal Reserve, the net worth of U.S. households reached a new all-time high of $70.35 trillion as of the end of March 2013. On an inflation-adjusted basis, net worth is about 4% less than its prior peak in 2007, but the recovery has nevertheless been impressive. Since the value of households' real estate holdings fell by $2.7 trillion since 2007, the increase in net worth was driven by $6.2 trillion worth of increased savings, reduced debt, and financial market gains. This is all a testament to the dynamic nature of the U.S. economy, which in turn reflects the ability of businesses, workers, and consumers to overcome adversity and forge ahead.

In my experience, it never pays to underestimate the inherent dynamism of the U.S. economy. It only took four years to recover from the most devastating recession in modern times, and the near-collapse of the global financial system. The recovery has been painfully slow, but there is no reason to think it won't continue.

Growth outlook modest to moderate

The latest edition of the Fed's "Beige Book" characterizes economic growth as "modest to moderate," and the ISM's May survey of the service sector says essentially the same thing. No sign of any pickup in growth, and no sign of any deterioration. Just more of the same: modest to moderate growth, which remains disappointing because it's not enough to significantly reduce the economy's idle capacity or the unemployment rate.

The survey of business activity improved marginally in May, but was otherwise unremarkable. Since the service sector is far more important than the manufacturing sector, this partially offsets the weaker trend in the manufacturing sector.

The prices paid index was neutral, just as it was for the manufacturing sector.

The employment index also was neutral, just as it was for the manufacturing sector. This reflects a lack of business confidence in the future, and portends more of the same kind of growth we've seen to date: modest to moderate.

Conditions in the U.S. service sector are "OK," while the Eurozone continues to struggle with contractionary influences.

Impressive recovery for car and truck sales

It may be an under-appreciated fact, but car and truck sales have enjoyed a rather spectacular recovery in the past four years. 

Although they haven't made new highs for six months, total vehicle sales in the U.S. have risen at a 13.2% annualized pace since hitting bottom in early 2009. That's over four years of double-digit gains.

Domestic light truck sales have done even better, rising at a 16.1% annualized pace over the same period, and now at a new post-recession high.

The dollar is still very weak, but up on the margin

I like to feature this chart every month because it is arguably the best way to judge the dollar's true strength against other currencies on a trade-weighted and inflation-adjusted basis. As it shows, while the dollar is still very weak from a long-term historical perspective, it is up from its all-time lows in mid-2011 (up 4.6% versus a broad basket of currencies, and up 11.6% versus a basket of major currencies). This fits with my prevailing theme that although the current recovery is the weakest ever, it is nevertheless the case that conditions are improving on the margin. It's the change on the margin, not the level, that is the most important from an investor's perspective.

Growth outlook remains modest

Today's ISM manufacturing report was weaker than expected, and is consistent with economic growth in the range of 1.5 - 2%, which is the pace of growth that has prevailed for the past three years. Manufacturing helped power the recovery in the first few years, but activity has moderated in the past year or so in a pattern that is fairly typical in the middle phase of economic expansions.

The May ISM manufacturing index came in at 49, below expectations of 51. Although this signals that slightly more firms reported that conditions had weakened from the prior month, this does not suggest that overall economic activity declined. As the chart above suggests, a reading of 49 is consistent with economic growth of 1.5 - 2%.

The prices paid component was neutral, suggesting that firms are not experiencing significant inflation or deflation pressures.

The employment component was also neutral, suggesting no future pickup or deterioration in manufacturing activity. For the most part, firms are not expecting any meaningful change in the environment.

The softening of activity in the U.S. manufacturing sector is offset to a degree by some marginal improvement in manufacturing activity in the Eurozone.

Construction spending in April rose a modest 0.4%, on top of modest upward revisions to the past few months' data, leaving total spending 4.3% higher over the past year. Nothing to get excited about here.

Construction spending represents about 40% of the broader "domestic private fixed investment" category, which includes equipment and software. Fixed investment has rebounded in the past three years from extraordinarily depressed levels, and this tracks well with the decline in the unemployment rate.

It's steady and (disappointingly) slow as she goes. Business confidence and willingness to invest needs to improve a lot more if we are to see any meaningful improvement in the economic outlook. So far there is no sign of that.