Between A Rock And A Hard Place

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Best jobs report of 2016 so far

Nonfarm payrolls rose 287,000 for the month of June, more than 100,000 beyond expectations.

This was an enormous increase from the paltry 11,000 jobs created in May (revised) and was the largest monthly gain we've seen thus far in 2016. Despite this, the unemployment rate rose for a good reason - more people were looking for jobs.

It is also worth noting that the number of persons employed part time for economic reasons (sometimes referred to as involuntary part-time workers) decreased by 587,000 to 5.8 million in June, offsetting an increase in May. However, wage growth remains on the tepid side, perhaps reflecting job creation in lower-paying industries.

Factoring the odds for a summer rate hike

Despite the strong jobs report on Friday, fed funds futures offer zero odds of a rate hike in July and just 12% odds for the September FOMC meeting. That's because the factors in favor of the Fed raising rates seem outweighed by the factors against the Fed raising rates.

First of all, the employment picture is not entirely rosy according to the June Labor Market Conditions Index (LMCI). This is a closely followed indicator by Janet Yellen and other FOMC members since it provides a more holistic read on jobs than the headline unemployment rate.

Although it has improved, it still remains in negative territory despite the strong June gain in non-farm payrolls. In fact, the LMCI just registered its sixth consecutive month in the negative column. In addition, the three-month moving average for non-farm payrolls is only 147,000, versus an average of 229,000 in 2015 and 251,000 in 2014, so labor market growth is still slowing.

Another factor is inflation. The FOMC June meeting minutes alluded to persistently weak inflation and inflation expectations as a source of concern among some Committee members. Despite the strength of the June jobs number, average hourly wages rose only 2 cents in June ($25.61 vs. $25.59) and average hours worked didn't change (34.4 hours). The lack of wage growth will likely remain a concern for the Fed at its next two meetings, especially if measures of inflation and inflation expectations remain tightly restrained.

It is worth noting that strictly from a base-effect standpoint, annual headline inflation - both the Consumer Price Index and the Personal Consumption Expenditure price index - is on track to grind northward in the months ahead, as previous declines in energy and import prices roll off. However, the Fed is concerned with core inflation; therefore we should follow measures of it very closely. The Fed's concerns are echoed in market concerns, with long-term inflation, or the lack of it, reflected in 30-year break even inflation rates dropping 0.3% to 1.6% in the last few months.

Brexit brings flight to safety

Another critical factor is the United Kingdom's historic Brexit vote. The Fed's June meeting took place just days before Britons went to the polls and the meeting minutes show that Committee members want to assess the impact of the Brexit vote on global market conditions as well as the US outlook.

Moreover, we know how seriously the Fed took the China threat just a few months ago. It seems that it will take time for the Fed to get a handle on the real implications of a Brexit vote, which suggests the Fed may need to hit the pause button on rate hikes for a while.

In addition, the Brexit vote has created fear among many market participants, resulting in a flight to safety-more specifically US Treasuries. The yield on the 10-year US Treasury continues to be driven lower and ended last week at 1.361%. The Fed may be forced to keep the fed funds rate at its current level in order to prevent an inverted yield curve as yields on the long end of the curve are pushed down by not only geopolitical uncertainty, but also foreign monetary policy.

Preventing upward pressure on dollar

Finally, the Fed may be forced to keep rates at current levels in order to prevent any additional upward pressure on the US dollar. We know how important exchange rates have become in the past year, as the strong dollar has weighed down on the manufacturing sector in the US.

While Purchasing Managers Index data suggest that manufacturing strengthened recently, new orders and shipments data for nondefense manufacturing suggest some weakening. The June jobs report indicates that manufacturing employment continues to lag other sectors, with virtually no new jobs created. We will need to follow the US dollar closely for indications of further strengthening, given the outsized impact it can have on the manufacturing sector.

It's no surprise then that the stock market reacted positively to the jobs report. The US economy appears to be improving but there are formidable factors that seem to be forcing the Fed to keep rates at current levels - at least for the time being. Expect lower for longer as the global hunt for yield continues - and grows more difficult to find.