Measuring The Risk To U.S. Employment: Why It Was Too Early To Give Up On Bonds

Dec. 02, 2019 9:33 AM ETEDV, IEI, SHY, TLT17 Comments38 Likes


  • Employment is the largest risk to the economic cycle and a major difference between the current economic slowdown and the prior three "mini-cycles."
  • A continued deceleration in employment growth will result in job losses in cyclical sectors of the economy. This eventuality will impact consumption growth, the commonly referenced "strength" in the economy.
  • With employment growth an active risk, it's far too early to remove the recession card from the deck.
  • It was too early for the bond market to "price-out" all rate cuts with recession risk still on the table.
  • While short-term bonds may offer a more attractive risk-reward, there's still upside for the Treasury curve which was the best trade for 2019.
  • I do much more than just articles at EPB Macro Research: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

Since the end of August, US Treasury bonds have been on a bumpy ride. Long-term bonds corrected more than 8% from August through the start of November before rallying about 4.5% into the end of the month.

Short-term bonds (SHY) had a much quicker peak-to-trough drawdown, falling 0.67% in two weeks before rebounding near the cyclical high.

As interest rates rose and the yield curve steepened, the bond vigilantes came out in full force. Just as quickly as the calls for 0% interest rates disappeared, the familiar 4% 10-year bond call was plastered in financial media.

The common thread among these extreme calls is the lack of a fundamental process and a view that can be reduced to "trend following." When yields are falling rapidly, pundits think 0% is right around the corner. When yields tick higher for a week, the 30-year bull market is over. Never do we hear a fundamental analysis behind the direction of growth or inflation, the only two factors that are relevant for Treasury bond investors.

While the risk-reward balance has shifted to the front end of the curve (SHY) (IEI) vs. the long end (TLT) (EDV), below we will analyze the biggest economic cycle risk (employment) and conclude that it was too early for the bond vigilantes to emerge.

Green shoots are emerging in various parts of the global economy. While long-term bonds are still a sound investment during periods of decelerating growth, the risk-reward profile has shifted in favor of short-term bonds for those who are more risk averse. Regardless of the spot on the Treasury curve you pick, the analysis on employment below argues that the market is woefully underpricing the risk of an employment downturn and gave up on bonds too early.

Based on several leading indicators of employment, the bond market pulled too many rate cuts out of the market too quickly. Should employment growth continue to slip, the Federal Reserve will likely be forced to respond by lowering interest rates, a benefit to the entire Treasury curve.

We will first analyze why US employment is the biggest risk to the economic cycle and conclude by discussing the risk-reward profile of short and long-term Treasury bonds.

US Employment: The Biggest Cycle Risk

Since the end of the financial crisis, the US economy, including today, has suffered four growth rate cycle slowdowns. While the jury is still out on the conclusion of the current slowdown, the prior three downturns were able to reverse before job losses were endured.

The term "manufacturing recession" is often used when the ISM PMI falls below 50, but even this is using the term loosely. A recession comes with job losses. As outlined below, the 2015-2016 industrial slowdown reversed before a period of job losses was sustained. Job losses for cyclical sectors of the economy are a major risk factor, an issue that has not plagued the United States since the last recession.

Let's take a look at why employment is the factor that separates this economic slowdown with the prior three, and why this slowdown is being underappreciated by the market.

Employment growth today, defined using a six-month annualized change formula, is at the weakest level since the employment market recovered in late 2010.

Private sector employment growth has decelerated sharply from a rate of 2.2% to 1.4%, the weakest in eight years.

Private Sector Employment Growth:

Source: Bloomberg, EPB Macro Research

The prior three economic slowdowns started with employment growth on a stronger footing than today's downturn. Starting from a lower point is a risk.

A common rebuttal to the rate of change analysis usually comes in the form of a "tight" labor market. Analysts suggest that "of course employment growth will slow if there are no more workers to hire."

This might be the case, in addition to an organic, monetary policy-induced slowdown, but without labor force growth, economic growth will decline without a corresponding rise in productivity growth, so the point is moot. Employment growth is a critical factor for total growth and aggregate consumption growth.

The decline in employment growth also is broad based. Private service sector employment growth has decelerated to 1.6%, nearly the weakest rate since 2011 as well.

Private Service Sector Employment Growth:

Source: Bloomberg, EPB Macro Research

Construction employment growth has seen a similar deceleration, falling from 5.5% to 1.7% growth.

Private Construction Sector Employment Growth:

Source: Bloomberg, EPB Macro Research

The manufacturing sector has experienced the most rapid deceleration, falling from 2.3% growth into contractionary territory.

It should be noted in the chart below, mentioned above, that the 2015-2016 manufacturing slowdown did not come with a sufficient period of job losses to be recessionary.

Typically, when studying cycles, a trend has to be in place for a couple of quarters. The economy never experienced sustained job losses, something that would have tipped the economy into a recession.

Private Manufacturing Sector Employment Growth:

Source: Bloomberg, EPB Macro Research

Today, we have reached a similar point. Manufacturing job losses have started while signs of a growth upturn in Europe are emerging. The problem is that the leading indicators of employment are still moving lower, arguing that the trend above may be sustained for several more months. A prolonged period of job losses in a cyclical sector, such as manufacturing, has the potential to start a "vicious cycle" in which lower employment growth leads to weaker income growth, faltering new orders growth, and declining production, reinforcing the original decline in employment.

Leading indicators of employment and manufacturing employment, more specifically, suggest that a sustained period of manufacturing job losses and a full "manufacturing recession" is still an active risk as we move into 2020.

The US economy will have a very difficult time avoiding a recession if the manufacturing economy does, in fact, fall into a technical recession with services and construction employment already in a downturn.

With only one rate cut priced into the Treasury curve over the next year, the market is underpricing the risk of protracted employment slowdown, forcing the Federal Reserve to continue lowering the policy rate.

The six-month trailing average in manufacturing payrolls is about -3,000. The average weekly hours worked in the manufacturing sector have declined by about 2.5% from the three-year high, a harbinger of weaker payrolls. Weekly hours worked remain a time-tested leading indicator of employment.

The current decline in manufacturing hours is consistent with recessionary periods and average monthly manufacturing job losses beyond 40,000.

Average Weekly Hours, Manufacturing Vs. Manufacturing Payrolls Growth:

Source: Bloomberg, EPB Macro Research

Adding overtime hours, the average weekly hours worked plus overtime hours worked in the manufacturing sector has declined by more than 3%, in line with historical recessionary periods and far outpacing the decline seen in the prior three economic slowdowns this cycle.

Not only is the current growth rate of employment weaker than the prior three downturns this cycle, but leading indicators of employment are outlining continued weakness.

Average Weekly Hours: Manufacturing, % Change From 3-Year High:

Source: Bloomberg, EPB Macro Research

At EPB Macro Research, our internal leading employment index, comprised of various metrics including average weekly hours, initial jobless claims, the short-term ratio, and the part-time ratio, also has moved to the weakest growth rate since 2009.

EPB Leading Employment Index:

Source: Bloomberg, EPB Macro Research

It's not only the manufacturing sector. Hours worked in the service sector also are declining. After smoothing the monthly data set, average weekly hours in the service sector are down 0.5%, a rate consistent with economic slowdowns.

Average Weekly Hours: Services, % Change From 3-Year High:

Source: Bloomberg, EPB Macro Research

Evidence of a slowdown in employment can be seen in other data sets as well. The Conference Board Consumer Sentiment survey has a section on employment. The employment section has indicators for jobs "plentiful," "not so plentiful" and "hard to get."

The spread between plentiful and hard to get is an important indicator of employment. The year over year change in this employment index also slipped into negative territory for the first since 2012.

The spread is materially below the 2015-2016 slowdown, similar to hours worked, the leading employment index, and the growth rate of total employment.

Conference Board Employment Spread:

Source: Bloomberg, EPB Macro Research

When looking at turning points, gathering information from a variety of data sources is helpful in weeding out false signals. Furthermore, the turning point should be measured across the time duration of the decline, the magnitude of the decline, and the breadth of the decline.

With leading indicators from the BLS, Conference Board, and Department of Labor, the deterioration is pervasive across many samples.

The employment slowdown also has been seen across manufacturing, construction, and service sector jobs.

Leading indicators of employment peaked in 2018, while actual employment growth marked a cyclical top in January of 2019. Ten months is more than enough time to check the duration box. The magnitude of the decline in employment is not yet sufficient to be recessionary.

The Bloomberg chart below shows that over the past 65 years, each time employment growth crossed below 1.2%, a recession occurred. It should be noted, however, that in each instance, employment growth continued below 0%.

Total Employment Growth:

Source: Bloomberg, EPB Macro Research

Leading indicators of employment, outlined above, make a clear case that a continued deterioration in employment growth, beyond today's 1.4% level, is an active risk and a risk that would cause the market to be mispricing the number of rate cuts from the FOMC.

The chart below is the 4-factor coincident index we use at EPB Macro Research. The coincident index takes a composite of total employment, industrial production, real core income, and real consumption. This index, in year over year form, is not meant to forecast future growth. The growth rate of this index is designed to represent the current pace of growth with the latest available data. Leading indicators forecast the future direction of growth.

EPB 4-Factor Coincident Index, Growth Rate (%):

Source: Bloomberg, EPB Macro Research

There have been four other instances where the coincident measure of growth has slipped to levels as weak as the current reading. In two cases, a recession occurred.

This note and the data presented above should not be misconstrued as a recession forecast. Leading indicators of aggregate economic growth have not checked the "magnitude" box needed to raise a red flag.

The main point is that economic growth is very weak, and more importantly, decelerating. This point cannot be debated as the coincident index above contains four of the most trusted and widely cited economic data points.

Leading indicators, specifically the employment indicators, suggest that the coincident index will move to the lowest non-recessionary growth rate we have seen since the 1980s.

The market is severely mispricing the possibility of several more rate cuts.

After overshooting, the bond market is starting to add back some rate cuts. We will look at what the market is currently expecting in the last section of this note — just a quick consideration.

Other Considerations

The Conference Board Leading Economic Index "LEI" has been a long-trusted indicator of growth.

The LEI has ten components outlined in the image below.

LEI Components:

Source: Bloomberg

The LEI has the luxury of a long track record. Prior to the previous seven recession over the past 50 years, the LEI has declined between 2.29% and 7.87% from the peak before a recession with an average decline of 4.90%.

LEI Drawdown:

Source: Bloomberg

Today, the LEI is 0.4% from the most recent peak, insufficient to check the "magnitude" box and raise the recessionary red flag.

Current LEI Drawdown:

Source: Bloomberg

The issue, however, is that once the magnitude of the decline becomes sufficient, it's often too late to react.

Looking at the rate of change shows the growth rate in the LEI decelerating since February 2018, and has cooled to a growth rate of 0%, the weakest of this economic cycle.

Analysts focused on the rate of change react to the change in direction of growth, rather than waiting for the nominal index to start declining.

Conference Board Leading Economic Index: Growth Rate

Source: Bloomberg, EPB Macro Research

As I mentioned in a previous note, the growth rate in the LEI still leads broader GDP growth.

Conference Board Leading Economic Index: Growth Rate

Source: Bloomberg, EPB Macro Research

The risk of a recession has not vanished with the appreciation in the stock market. Economic growth, based on the coincident index, is near the lowest "non-recessionary" period since the 1990s, and the leading indicators of growth suggest more downside is to come.

Leading indicators of employment specifically suggest that the employment segment of the economy is particularly exposed to an ongoing slowdown.

While the time to raise the recession flag has still not come, the slowdown started more than 20 months ago.

The risk of a recession in the US economy is still present and arguably greater, despite the rally in stock markets globally.

The US Treasury market overreacted as well but now poses a great risk-reward opportunity to navigate the conclusion of this economic deceleration.

Short-Term Treasury Notes: A Stellar Risk-Reward

Long-term readers of my research are aware that at EPB Macro Research, we were very bullish on long-term bonds. In October 2018, when interest rates were breaking out above 3.25%, I wrote a note saying to buy long-term bonds.

If you buy long-term bonds today, it will prove fruitful as we have not yet seen the secular low in interest rates.

Buying a 3.35% 30-year Treasury (TLT) with the potential for new secular lows in interest rates over the next several years has enormous profit potential.

I am still a buyer of the long bond.

"Should You Be Worried About This Rise In Interest Rates?" - October 11, 2018

At the end of August, the 30-year Treasury rate closed at a new secular low of 1.94%, marking a 50% rally for long-duration bonds.

At the end of September, I reduced my allocation to long-term bonds due to portfolio volatility parameters. I remain bullish of long-term bonds (TLT) (EDV) until growth changes direction, and the risks to employment are diminished.

While I maintain a bullish stance on duration, the risk-reward profile has shifted, and I hold these positions at roughly 30% of their prior weighting.

The risk-reward profile for short-term Treasury bonds is stellar.

From November 2018 through October 2019, the 2-year Treasury rate fell 157 basis points and had a total return of roughly 4.2%.

Today, at a rate of 1.58%, the 2-year yield is just 19bps away from its cyclical low.

In the past month, the bond market has fluctuated massively. In September, the two-year forward market implied policy rate hit a low of 0.68%. This means that in September, the market thought that the lowest the Fed Funds rate would be over the next two years was 0.68%.

A Fed Funds rate of 0.68% is about 95bps lower than today's rate. In other words, in September, the market was pricing in about four additional rate cuts from today's level.

2-Year Forward Market Implied Policy Rate:

Source: Bloomberg

In the middle of November, these expectations had shifted and the market-implied policy rate two years ahead rose to 1.49%. An implied rate of 1.49% is just 14bps below today's policy rate, implying that the market pulled out all possible rate cuts over the next two years, a very extreme position given the employment risks outlined above.

Today, yields have resumed their decline as the market is now expecting about 36bps of rate cuts over the next two years.

Depending on the path it takes, in a recessionary scenario, 2-year bonds could achieve a total return of nearly 5% from here.

From August 2017 through May 2018, during an aggressive tightening cycle, 2-year bonds, proxied through ETF (SHY), only had a total return drawdown of -1%.

ETF SHY: Total Return Price: % From High

Source: Bloomberg, EPB Macro Research

Even the most optimistic growth bulls do not expect another tightening cycle, which makes a cautious downside risk in short-term bonds about 1%. The nearly 5-1 risk-reward ratio is highly compelling.

Investors can leverage this position or express a bet on short-term bonds in a variety of instruments. Regardless of the leverage, the risk-reward profile stays constant, the expected return/loss is just magnified.

I remain bullish on long-term bonds but see short-term bonds as a better risk reward, especially in the context of accelerating growth in Europe.

The recent funding stress may cause the Federal Reserve to lower short-term rates to 0%, regardless of economic growth, but that's for an entirely separate note.

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This article was written by

Eric Basmajian profile picture
Tracking Economic Inflection Points To Guide Your Asset Allocation Strategy

Eric Basmajian is an economic cycle analyst and the Founder of EPB Macro Research, an economics-based research firm focusing on inflection points in economic growth and the impact on asset prices.

Prior to EPB Macro Research, Eric worked on the buy-side of the financial sector as an analyst at Panorama Partners, a quantitative hedge fund specializing in equity derivatives. 

Eric holds a Bachelor’s degree in economics from New York University.

EPB Macro Research offers premium economic cycle research on Seeking Alpha. 

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Disclosure: I am/we are long SHV, SHY, IEI, EDV, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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