August Employment Report

The August employment report came in with a bang. While the consensus prediction for payroll employment was around +110,000 (I had figured around +50,000), the figure released by the Bureau of Labor Statistics was -4,000 -- the first month-to-month decline in four years. Ouch!! You can read about the report.

As I stated in class, this would clearly be one of those "other things are not equal" situations. On the one hand, a weak employment report further fuels the expectation that the Fed will lower rates at its next meeting on 9/18, possibly by 50 basis points (1/2 of a percentage point). That is a positive for the stock market (which is driven primarily by profit expectations and interest rates).
But, weak employment signals less spendable income in future months, which will cut into profits, a negative for stocks. Which effect would dominate? As the morning unfolded it became readily apparent that the negative aspects were more than offsetting the positive factors.

But how could this be? If the Fed will be lowering interest rates soon, and the unemployment remained unchanged, why so negative a reaction by the markets? That's where it is necessary to read the details of the report. First, let me state a rule for judging reports: NEVER PLACE TOO MUCH WEIGHT ON A SINGLE MONTH'S VALUE. Actually the markets didn't. As it turned out, the employment totals for the prior two months were revised sharply lower. This brings me to a second rule: ALWAYS LOOK AT REVISIONS TO PRIOR TIME PERIODS BEFORE JUDGING THE CURRENT VALUE. So, instead of having an average monthly employment gain of around 110,000 over the past three months, the average (with revisions) becomes only +44,000. In addition to this, a further examination of the unemployment rate is called for. While the unemployment rate remained unchanged at 4.6%, the labor force dropped sharply. Had the labor force participation rate (% of population in the labor force) remained the same as it was last month, August's unemployment would have surged to 5%. Now it should become more apparent why the negative reaction occurred.

It is important to keep in mind that the primary factor determining whether a recession is upcoming is whether housing weakness is "contained." The dominant view has been that as long as employment remains strong and the unemployment rate doesn't rise too much, persons should generally be able to afford their mortgages, limiting housing damage. Well, in August, employment fell and the unemployment rate should have risen (with the same participation rate as last month). So, it is not clear how much "containment" will exist going forward, raising the likelihood of a recession (my estimate this entire year has been 45%, well above the consensus until very recently). Add to this the fact that a very large number of mortgages will be "resetting" to higher interest rates in October, and you can see the basis for the stock market selloff. Here's an article highlighting whether a recession is likely.

While we haven't covered it yet, another big reaction to the weak employment report was a sharp drop in interest rates. The 10-year government bond, which is linked to mortgage rates, fell from 4.50% to 4.37%, a 13 basis point drop in one day!! Bonds are fixed (nominal) income assets, meaning they pay fixed amounts of income per year. "Bad news" about the economy, like this employment report, is good news to the bond market as it implies less of an inflation threat in the future (inflation lowers nominal income). And, we will see (later this coming week) that bond prices and interest rates move in opposite directions. So, on Friday we had a stock market sell off and a bond market rally!! Finally, not unrelated to all of this was a sharp rise in gold prices. See if you can figure out gold prices rose. (Hint: it is related to interest rate changes.)

All of this should demonstrate the point I made the first day of class: if you understand macroeconomics you tend to think in terms of sequences (sets) of variable changes, not just what is happening to a single variable. The ability to do this takes practice. Judging by the way this semester has started, you'll be getting lots of practice!