U.S. Bond Market Week In Review: Yellen Is Overestimating Economic Strength

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Includes: EGF, FTT, GOVT, PLW, RINF, TAPR
by: Hale Stewart

Before delving into this column's details, I feel obligated to state that I have a very deep admiration for Chairperson Yellen. She is a very accomplished economist and perhaps the most qualified person to ever lead the Federal Reserve. That being said, I believe the data shows she is misreading the strength of the economy. And if that's correct, then her expressed desire to raise rates would be a mistake.

Let's begin with her analysis of the U.S. labor market:

I will turn to this past Friday's labor market report in a moment, but let me begin with some background: The economy added 2.7 million jobs last year, an average of about 230,000 a month. In the first three months of this year, payrolls were growing only modestly slower, at a little less than a 200,000 monthly pace. The unemployment rate had fallen to 5 percent, down from a peak of 10 percent in 2009. In addition, the Bureau of Labor Statistics' measure of the job openings rate was at a record high in March, and the quits rate - the share of employees voluntarily leaving their jobs - has moved up and in March stood close to its pre-recession levels. The increase in the quits rate is a sign that workers are feeling more confident about the job market and are likely receiving more job offers.

Yellen uses the payrolls and JOLTs (Job Openings and Labor Turnover) survey to argue the U.S. labor market is strong. These indicators strongly corroborate her argument: payroll growth has been strong, the unemployment rate is 5%, and job openings are at a record high.

But several other labor market indicators offer a very compelling counter-argument, starting with wage growth. A 5% unemployment rate should increase wages to such a sharp degree that inflationary pressures result. But this isn't the case:

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The Atlanta Fed's wage tracker shows that after expanding for 8 years, pay growth is just now near the lowest level of the last expansion. If the 5% unemployment rate were truly representative, wage growth should be higher. Meaningful weakness clearly exists underneath the surface, which is best explained by the U-6 unemployment rate (that measures total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons):

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The chart above shows total payroll growth in blue and U-6 in red. While the blue line points to a very strong economy, the red line illustrates a much softer labor market. The Atlanta Fed's Labor Market Spider Chart illustrates the same data in a different way:

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All current labor market metrics (leading, employer behavior and confidence) are either at or higher than previous highs. But utilization, which shows how effectively and efficiently the economy is employing labor resources, is not. In fact, the preceding chart shows that the current U-6 level is just now at the highest level attained in the last expansion. This is hardly indication of labor market strength. And the combination of weak wage growth and high under-utilization of labor resources strongly counters Yellen's assertion that the labor market is in strong shape.

Next, Yellen argues that future growth should be strong enough to support a rate hike. But the CEIs, LEIs and long leading indicators don't support that assertion. Let's start with the Conference Board's indicators:

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The top table shows the monthly change in the LEIs and CEIs. The LEIs were grinding to near 0 in late 2015 and early 2016, but increased .6% in the latest report. It's far too early to tell if this is a temporary bump or the beginning of a new uptrend. The monthly change in the CEIs (second row) has been just barely positive for the last six months. The bottom table shows the 6-month rolling average. While the LEIs (3rd line) have been grinding lower save for the latest reading, the CEIs have been printing consistently around the .7/.8% area. According to the Conference Board's Analysis, this is consistent with moderate near-term growth.

And the 4 long leading indicators don't predict growth at the levels Yellen asserts, starting with corporate profits, which have moved sideways since the end of 2011 and declined in 4 of the last 6 quarters:

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Building permits are moving sideways:

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To her credit, M2 growth and Baa yields show some expansion:

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But the two indicators that measure business activity counter-balance the positive interpretation of the financial indicators, indicating growth will be middling at best.

For the duration of this expansion, the Fed has continually overestimated the potential strength of U.S. economic growth. Part of this is due to the Fed's highly visible position; to a certain extent, they have to cheerlead the economy. But it has also become obvious that the Fed's model is not entirely in-sync with the current economic fundamentals, leading to a divergence between the Fed's estimates and actual economic performance. It appears the same dynamic is currently in play with Chairperson Yellen.

Hale Stewart, XE.com