The huge 254,000 increase (remember that on average a 150,000 monthly increase is normal in an economic recovery period) in non-farm payrolls on Friday night was a shock – even for our expectations. The market was expecting a 140,000 increase and no revisions to July or August. Not only was the September reading very strong the labour department also revised up the July number from 89,000 to 144,000 and the August number from 142,000 to 159,000. Historically the unemployment rate has remained steady with employment growth averaging 125,000 per month, but what we need to appreciate here is that in the US there has been a huge increase in immigration and that labour participation is near record levels at a time when labour productivity is increasing.
The following chart shows several things:
- On average employment growth is not declining but stable at or near a level above that which if population growth was not increasing would have driven the unemployment rate lower.
- The strong employment growth as the pandemic restrictions were eased in 2021 is an anomaly caused by the fiscal and monetary stimulus used to address the shock. We need to be viewing the current employment growth levels through the long-term pre-pandemic levels and not conveniently comparing them only to the above average 2021-22 levels.
- The unemployment rate has risen since the early 2023 low point; however, it needs to be acknowledged that the economy has been strong enough to absorb both the sharp increase in population growth since 2020 (blue line) and the strong levels of labour productivity (red line) at 2.5%. At a firm level an owner is always searching for a way to increase labour productivity – it is the eternal search – so some increase in unemployment should have been realised from the labour productivity increase since 2021. It was not because the underlying economy is apparently much stronger than the Federal Reserve is willing to acknowledge.
Friday night was a pretty bad night for US Federal Reserve credibility. If it had cut rates in September by only 25bps it could have been forgiven for hedging its bets – despite the extraordinary access to forecast data that everyone expects the Federal Reserve to have. When the Federal Reserve cut rates by 50bps every market commentator and nearly the entire universe of market participants just accepted that the Federal Reserve with its unique insight ability was confident that the US employment market – as represented by the July and August employment numbers- was going to get worse. It has instead recovered dramatically.
On the 1st of September, ahead of the FOMC meeting, we said that the non-farm payrolls data for August would need to confirm the weakness seen in the July numbers. It did then, but only a month later it certainly does not. We have never understood the irrational infatuation that the markets have with the non-farm payrolls data for the following reasons:
- If nothing else the hefty revisions over the past 6 months of the employment data by the Labour Department should have raised questions about the methodology used to collect and estimate the data.
- We have now been told in the following WSJ story that the Labour Depts division responsible for the non-farm payrolls data is heavily underfunded. Can We Still Trust the Unemployment Rate? – WSJ
- It is a lagging indicator. The true and real decision to increase or decrease employment by any firm is made 6-9 months earlier and should be apparent (at least as it was pre-pandemic) from leading indicators such as:
- ISM PMI data
- Imports
- Changes in inventories
- Changes in business investment
- Population growth changes
If the Federal Reserve had also seen the ISM PMI Composite index fall below 50 in August its case for the 50bps rate cut would have been more reasonable, however, the ISM PMI Composite index was pushed back above 50 due to the increase in the ISM Services PMI to 51.4, but it was the increase in the ISM Services PMI Prices Index that we found most concerning. The ISM Services PMI prices index increased to 59.40 with the September data release, the highest reading since January and up from 57.3 in August. It was way above forecasts of 56.3. This forward-looking indicator is telling us that firms in the services sector are expecting to pass on the wages growth of 3.8% pa onto consumers in 6-9 months’ time.
In the US a decline/increase in imports has a been a reliable indicator of a change in GDP roughly one quarter ahead. This signal actually occurred in the December quarter of 2019, but we did not believe it then. Imports have been trending higher since the December quarter of 2022. This outcome was expected given the strength of the USD (due to the tight monetary policy driving up US rates) and would be the transition mechanism by which US durable goods prices have been falling. Both the import and export levels over the past 2 years are consistent with a robust underlying economy.
One of the key forward indicators we use is the change in private business inventories and this is in fact increasing in 2024 from an already very high level.
Interest Rates
Rates jumped on Friday night after the stronger nonfarm payrolls numbers. It was however the stronger ISM PMI services index data on Thursday night that ignited the increase in yields. Last week the 5-year bond yield rose from 3.5% to close at 3.81%. The 10-year yield increased from 3.8% to close at 3.98% and the 2-year from 3.56% to 3.93%. The markets’ hopes of further rate cuts this year just died.
Australian bond yields tracked changes in the US yield curve last week. The only piece of significant data released was the much stronger than expected retail sales number at +0.7%. A solid retail sales number was already expected but in the absence of discount sales and ahead of the school holidays, this strong number shows consumers are spending their tax cuts and the electricity subsidies. Australian 10-year yield increased from 3.96% to 4.06% but is likely to open trading on Monday at 4.18%. The 2-year yield rose from 3.59% to 3.68%.
Major Credit Markets
U.S. investment grade margins barely moved last week despite the increase in geopolitical risk. Globally September was a record month for both gov. and corporate issuance, however an increase in issuance of the next month is expected to see corporate margins widen from current tight levels.
The Australian iTraxx index increased to 65.5 however major bank margins were nearly unchanged at a senior level. Bank Tier 2 margins were on average four basis points tighter with five year margins trading now at 167 basis points. Australian semi government bonds are now trading very cheap relative to US A-rated corporates (coca Cola etc). Within the semi government universe TCV bonds look cheap relative to others, however there is a reason for this – Victoria is facing a financial reckoning. While it is true that under the constitution the Commonwealth government would step in and make good any missed coupons for Vic, it would subtract this from the grant money awarded which would only worsen the budget situation. Responsible fiscal behaviour is required.
High Yield Markets
US high yield (HY) markets were strong on huge demand with all HY sub sectors sought. This is based on fears of a recession fading and Friday’s strong payroll report. Primary issuance in September was the busiest month in three years & within October, so far, (four days) issuance has exceeded that in October 2022. A third of the issuance volume has been in “BB” rated securities. HY margins are at 2-year lows.
Hybrids rallied last week despite major bank share prices falling further, reversing the trend from the week before that saw weaker hybrid prices with the strong pull back in banks share prices. Last week the average major bank hybrid margin fell by five points back below 1.90% to 1.88%. Volumes remain slightly elevated as buyers still chase longer term hybrids, especially MQGPG, AN3PK and NABPK.
Listed Hybrid Market
Hybrids – relative to Corporate credit getting tight again
We often compare hybrid margins to the iTraxx index, a measure of the top 25 Australian IG rated wholesale bonds. The recent hybrid rally simulated by the APRA discussion paper has pushed the ratio of the average major bank hybrid index to 12-month lows (arrow), despite the iTraxx being near lows. In 2022 this ratio looked like it had been re-rated (see circle) when in fact it was a period when hybrids were keenly sought, given they were a major way ASX investors could get exposure to rising bank bill rates. Hence given this is not the case now, the only way hybrids will re-enter an expensive to iTraxx phase again would be from further strong hybrid demand given the potential scarcity factor from the potential APRA changes. As we have had lower ratios before, it could occur again. The ratio is on the verge of this occurring.
Forward Interest Indicators
Australian rates
Swap rates rise with bond rates.
Swap rates:
- 10-year swap 4.23%
- 7-year swap 4.09%
- 5-year swap 4.01%
- 1-month swap BBSW 4.30%
