Antibiotics For A Viral Economic Problem

2019 déjà vu: Fed cuts couldn’t fix a trade-war hiring slowdown then–and won’t now.

KEY TAKEAWAYS

• August unemployment rose to 4.3% and payrolls added just 22k with negative revisions

• Jobs growth is in a clear decelerating trend that threatens consumption and GDP

• Markets priced in near-term Fed cuts while equities sold off on growth fears

• Tariff-driven uncertainty is freezing hiring and showing up in Beige Book anecdotes

• Rate cuts are necessary relief but cannot solve a policy-created labor slowdown

MY HOT TAKES

• This is 2019 all over again–monetary easing cannot cure a trade shock

• The Beige Book is the real tell–attrition over additions equals stealth layoffs

• Markets are overvaluing cuts and undervaluing clarity

• Beware of choppier consumption data as hiring paralysis bleeds into Q4

• You can quote me: “Lower interest rates cannot fix a labor market problem that is caused by trade policy uncertainty, just like antibiotics are ineffective against the Flu.”

Belaboring the point. In case you missed it, on Friday, the Bureau of Labor Statistics (BLS) released its monthly employment situation data for August, and it was… well, not too pretty. To start, the headline Unemployment Rate rose to 4.3% from 4.2%. The fact that it was expected is less important than the fact that the gain represents a continuation of a trend that started at the beginning of the year. For a bit more context, the print was the highest since October of 2021 when it was in a post-pandemic downtrend.

The other closely-watched headline series from Friday’s release is the Monthly Change in Nonfarm Payrolls. The number came in far lower than the expected 75k additions at 22k, another weak print in a series of soft releases. Revisions actually showed a loss of nonfarm jobs in June. Folks, there is no way to candy coat this development which shows a clear deceleration in job growth. Check out this chart and keep reading.

This chart shows New Monthly Nonfarm Payrolls (white line), and you should be able to clearly identify the decelerating trend. Let’s take a step back and think about the implications of this. When folks are out of work or believe that their job prospects are weak, they cut back on spending. Consumption represents around ⅔ of GDP, so yes there is a causal relationship between jobs growth and GDP. I will spare you the 5-year chart that shows a longer-term, secular trend starting in 2022. However, this year's trend shows an increasing deceleration, which only adds to the worry.

In the wake of the release, unsurprisingly, bets of upcoming Fed rate cuts jumped, and bond yields fell. Why? Because full employment ½ of the Fed’s dual mandate. To be clear, the Fed is surely aware of this trend of weaker employment, but they have chosen to ignore it in favor of the other half of its mandate: inflation control. Inflation has been sticky and ticking slightly higher in recent months. The thesis for the rising inflation is that tariffs are being passed on to consumers. Though there is some evidence of that being the case, it is still unclear as to what the magnitude of it is or how long the effect will last. It is more likely a one-time price increase. While that is not a good thing for consumers, the fact that it is transitory should keep the Fed satisfied that it is not likely to turn into a 2021-2022 inflation dumpster fire. Still the Fed has responded by keeping rates unchanged in their restrictive state leaving many to believe that the central bankers have once again been caught on their heels having to react to worsening conditions.

The embattled Fed Chair appeared to relent in his Jackson Hole comments last month which sent bets of a near-term rate cut higher, and Friday’s release put a cherry on top. The Fed must now focus on decaying employment conditions. According to futures, there is now a 100% chance of -25 basis-point cut next week with only a 10% chance of the cut amounting to -50 basis points. Futures give rates a 100% chance of -50 basis points and a 78% chance of -75 basis points lower before the end of the year.

Bond yields also declined in response to Friday’s release with the 2-year Note giving up -7 basis points and 10-year yields pulling back by -8 basis points. The yield declines are further proof that markets too are focused on the weak numbers. The equity markets for their part decried the release despite the increase in chances of rate cuts. Friday’s decline in equities reflected the markets’ worry of weakening economic conditions. Bad was bad on Friday.

The week ahead includes 2 important inflation numbers from BLS–Producer Price Index / PPI and Consumer Price Index / CPI. It is the last bit of direct inflation and or employment data before the Fed get-together next week. Though inflation is expected to have picked up last month, if the numbers come in as expected they are likely not going to have a material impact on the Fed’s decision given the magnitude of the weaker employment numbers.

At this point markets are counting on at least a 25 basis-point cut next week and would like to hear some guidance of further cuts. Anything short may stall markets, anything more may provide some tailwinds for the stalling equity rally.

All this begs an unpopular question, which I must ask: can cuts of 25, 50, or even 75 basis points reverse the declining trend in jobs growth minimizing GDP growth declines? To answer that question, we need to put our finger on what the cause of the declining conditions is. Are companies slowing their hiring because their cost of borrowing is too high? Of course not! When rational companies are unsure about business conditions in coming months, they cut back on expenditures–hiring and capital investment. It’s just rational!

Now, I am pretty sure you didn’t miss it, but there is a bit of uncertainty around the effects of trade policy, not just by the markets, but by companies themselves. Companies have not yet experienced the full effect of the tariffs, nor have they been able to fully test the markets to determine how much, if any, price increases would be tolerated by consumers. Last week’s Fed Beige book gave evidence that companies are indeed seeking to slow employment by cutting back on hiring enabling natural attrition to decrease the workforce. 

We have seen this happen before. Can you guess when? How about 2018 and 2019 when the first trade war broke out between the US and China. We saw the nonfarm hires numbers, which were averaging in the 200k plus range, decay to below 200k in 2018 and further yet in 2019. Beige Books back then were full of references to tariff uncertainty. Looking at the longer-term payroll adds trend during those years, we witnessed a secular decline leading up to the onset of the trade war, but the decline clearly accelerated as the tensions rose. In fact, the trend looks very similar to how it looks right now. There is one notable difference. The Fed was actually cutting interest rates in 2019, but the decline in jobs growth continued. 

Lower interest rates could not fix the labor market problem that was caused by trade policy uncertainty. That’s right, lowering interest rates was like prescribing antibiotics for a viral infection. Unfortunately, we are likely in a similar situation today as companies pull back on spending plans in an attempt to minimize any fallout from recent trade policy challenges. Let’s be clear, lower rates are necessary at this point as a salve for the symptom–a weakening economy, not the cause–a pullback in hiring resulting from trade uncertainty. Worried that cutting rates too soon will inflame tariff-based inflation? It may, but keeping rates high won’t fix the problem either. Rate adjustments in either direction are useless against supply push inflation.

The Fed is in a tricky situation at this point. It must cut interest rates and it knows it. However, it also knows that cutting rates won’t fix the cause of the employment problem. Only time and administration policy can achieve that.

FRIDAY’S MARKETS

Stocks declined on Friday as the bad economic news that would secure near-term rate cuts frightened investors. Small-cap stocks gained in response to prospects of lower interest rates. Bond yields declined and the yield curve shifted downward.

NEXT UP

• No major economic releases today, but later this week we will get Producer Price Index / PPI, Consumer Price Index / CPI, and University of Michigan Sentiment. Download the attached calendar to get to skip to the front of the line of uninformed investors.

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