Strong Labor Market Lends Itself To More Fed Hikes, But Not For Long

Friday’s amazing job numbers — which continue to hit it out of the park — mean that no matter how often Wall Street talks itself into a Fed rate pause, it’s not going to happen any time soon. Barring a crash in commodity prices, inflation will need to fall to 5% before the Fed hits the brakes.

“The fed will hate this set of numbers,” says Brian McCarthy, head of investment research firm Macrolens in Stamford, Conn. “January payrolls are always wonky due to annual revisions and an extreme seasonal adjustment, but with both hourly earnings and hours worked also looking much more robust than we were led to believe last month, there is no denying a picture of continued strength in the labor market, which is at odds with a gathering stream of layoff announcements.”

The Federal Reserve already raised interest rates a quarter-point this week, its eighth hike since March. Those hikes, of course, could help slow the economy. The job market, meanwhile, is signaling no slowdown in sight.

Said one market participant about the Bureau of Labor Statistics numbers today: “the reading was so good we had to check it twice to make sure that there was nothing wrong there. The US labor market is not only strong, it is robust, and concerns about recessions are unnecessary.”

Investors know the Fed may adopt a more hawkish monetary policy than they would like because of the job market. To them, when everyone is working, everyone is spending money on things like chicken and gasoline and inflation rises. For Wall Street, cheap credit is good for leveraged trades, and Wall Street still loves leverage trades despite the 2008 fiasco. Moreover, companies seemed to have had no major problems with rising rates, and mortgage rates have come down.

Higher Rates = Slower Economy?

The higher cost of capital has not led to any meaningful slowdown of the U.S. economy. American GDP growth is beating the EU, and unemployment is at its lowest level since the late 1960s.

But on Wednesday morning, former New York Fed economist Arturo Estrella tweeted out “#Recession alert” on his Twitter page, showing a chart of the yield curve inversion that began in mid-October and continues to this day. Everyone loves a doomsayer, right?

The charts suggest a recession is looming. According to Estrella’s own quantitative model, recession odds were 99% before the Fed’s tightening on Feb. 1.

This is not consensus view, even though inverted charts like that will always get the recession alarm bells ringing.

Others plugged into financial Twitter have seen guys say that if this is a recession, this is a pretty good recession. In other words, if there is going to be a recession, this is the kind you want.

Fed Chairman Jerome Powell said this week he was still concerned about inflation, but was ready to act if inflation fell more than expected. Twelve-month rolling inflation is 6.5% as of January 12. It was over 8.5% late last year.

A weaker dollar has helped. The weaker dollar appears to be the glidepath by which the Fed hopes to stick a soft-landing and not hit a real recession.

“If the Fed is just months away from a pause and a couple of quarters away from reducing rates, it’s possible the expected slowdown need not be much worse than what the economy experienced during the first several months of the recession that began in late 2007,” says Vladimir Signorelli, head of Bretton Woods Research, a macro investor research firm in Long Valley, New Jersey.

A soft-landing scenario — where the economy slows to 4.8% unemployment from around 3.5% today — will require the Fed to reduce interest rates before the end of the year and likely even more quickly than they were raised. If they keep raising rates as unemployment rises, the economy could get away from them.

There are other moving parts. If the Ukraine war comes to a diplomatic solution by the middle of the year, a soft-landing scenario is also more realistic, as the dollar strengthens on more geopolitical stability. Foreign investors will be buying U.S. stocks, adding to the dollar’s strength.

Some businesses told me this week that their warehouses are full, but orders are slowing. Most of the fill-up is due to the 2021 supply chain woes caused by pandemic policy restrictions. China’s Zero Covid policy of on-again, off-again lockdowns had everyone stocking up. The long lines at the ports, however, are over. Ocean freight bookings are a fraction of what they were just seven months ago, as the must-read maritime shipping reporter Lori LaRocco wrote in her Freight Waves column this morning.

We may see inflation fall faster than expected, afterall.

Because of this…

“We think we will start to see rate reductions in the next six to 12 months,” Signorelli predicts.