Tariff fears trump modest jobs growth

Today's December private sector jobs report beat expectations (223K vs. 140K) and that supposedly triggered a sharp, negative response from the bond market. Interest rates are now priced to only one more cut in the Federal funds rate for the rest of this year. As a result, in the past few months short-term interest rates have jumped by almost one percentage point, 10-yr Treasury yields have jumped by more than one percentage point, and 30-yr mortgage rates have risen to almost 7%. 

But the perceived health of the jobs market wasn't the only thing that rattled the bond market today. Another contributing factor was the Fed's fear (shared by the market) that Trump's threatened tariffs would boost inflation, as revealed in the minutes of the last FOMC meeting. From mid-August, when Trump's probability of winning the election bottomed, 5-yr average inflation expectations have jumped from 1.87% to 2.54%. In any event, it remains the case that inflation is not caused by a stronger jobs market or stronger economic growth: growth has soundly beat expectations in recent years even as inflation has declined significantly.

 

Whatever the cause, higher rates and higher inflation expectations effectively put the kibosh on hopes for lower mortgage rates, and thus will likely worsen the prolonged period of historically weak home sales, housing starts, and new mortgage applications which began over two years ago. Sadly, it will add insult to the injury of many thousands of displaced Los Angeles area residents seeking to rebuild or replace homes lost to multiple fires.

As I see it, the rationale for today's sharply higher rates and slumping stock market has weak underpinnings: the mistaken belief that tariffs will boost inflation and thus require tighter-than-expected Fed monetary policy. 

Chart #1

Chart #1 shows the monthly change in private sector payrolls over the past 3 years. Note how volatile this statistic is on a month-to-month basis; that anyone—especially the Fed—would use just one month's number as a basis for important long-term policy decisions strains credulity. But that's what happens every now then, with today being a prime example. 

Chart #2

Chart #2 uses a more realistic approach to interpreting the state of the jobs market, by focusing on percentage changes in jobs over 6- and 12-month periods. By either measure there has been a dramatic slowdown in jobs growth in recent years. At best, jobs currently might be growing at a 1.3% annual rate, which is marginally lower than the 1.4% annualized rate that has prevailed over the past 30 years (a period that includes three recessions). Current jobs growth is moderate at best.

Chart #3

Chart #10 shows the level of 10-yr Treasury yields, which is the benchmark for all long-term interest rates (including fixed-rate mortgages). Simply put, interest rates have exploded higher in recent years. Only abundant liquidity has kept this from tanking the markets and the economy. (For a longer explanation, see this post from last November.)

Chart #4

Chart #4 compares the level of fixed rate mortgages to an index of new mortgage applications (as opposed to mortgage refinancings). The plunge in new applications reflects a similar plunge in new home sales and housing starts. In effect, sharply higher rates have crushed the housing market. 

Chart #5

Chart #5 compares the level of real yields on 5-yr TIPS to an index of the dollar's strength vis a vis other major currencies. Rising real yields are an excellent measure of how tight monetary policy is. Not surprisingly, tight money and high real yields have significantly boosted the dollar's appeal. A strong dollar positively impacts our purchasing power while also keeping imported goods prices low; indeed, a strong dollar is an excellent defense against inflation, especially when accompanied by tight monetary policy. 

Chart #6

As I mentioned in my last post, a strong dollar puts downward pressure on commodity prices. Indeed, industrial commodity prices have declined in both real and nominal terms over the past two years, as shown in Chart #6, thanks to a strong dollar.

Monetary policy is tight and has become tighter of late, as the market and the Fed worry about the presumably inflationary impact of Trump's tariffs that have yet to be imposed. It makes much more sense to believe that Trump's promises to significantly lower tax and regulatory burdens will deliver stronger growth with low inflation.

Monetary policy trumps tariffs

There's no need to worry about Trump's threatened tariffs causing another bout of inflation. Inflation is a monetary phenomenon that can only be caused by excess money, not artificially jacked-up prices. A sound monetary policy deals with rising prices for some things by forcing the prices of other things to decline. It's like living on a fixed budget—if you have to pay more for something that means you have to pay less for others. 

This post reviews the monetary variables that matter most, and concludes that monetary policy is consistent with inflation remaining low and relatively stable; i.e., monetary policy today is sound. Indeed, we are more likely to see lower inflation than higher inflation this year.

M2 growth has normalized, and now is running at the same annual growth rate which prevailed from 1995 thru 2019 (~6% per year)—a time during which CPI inflation averaged 2.5% per year and PCE Core inflation averaged 2.0% per year (PCE Core is the inflation rate the Fed prefers to target). After surging in the wake of Covid stimulus spending and declining as the Fed raised interest rates, demand for money today is only modestly higher than it was in the pre-Covid period, Moreover, money demand appears to once again be stable. Meanwhile, the dollar remains very strong, credit spreads are low, real yields are high, the yield curve is steepening, lending is increasing at a modest pace, and liquidity conditions remain healthy. All consistent with relatively low and stable inflation.

The bad thing about Trump's threatened tariffs is that they could disrupt trade and slow global economies (including ours). If—as many of Trump's supporters suspect—tariffs are a bargaining chip and will prove only temporary at best, then markets may suffer a case of the jitters which should resolve over time. 

Chart #1

Chart #1 shows the level of the M2 money supply, which is widely considered to be the best measure of the amount of spendable money in the economy. The US money supply increased at a roughly 6% annual pace from 1995 through the end of 2019. It then surged in unprecedented fashion as the government sent "stimulus" checks totaling some $6 trillion to households and businesses in an effort to counteract the contractionary impact of Covid -related shutdowns. As stimulus checks ceased in late 2021 and Fed interest rate hikes began to bite, M2 growth not only slowed by turned negative. M2 today stands at the level it first attained 3 years ago, and it is growing at about the same rate as pre-Covid.

Chart #2

Chart #2 shows the level of US currency in circulation, which makes up just over 10% of M2. Currency is the one monetary measure whose demand always equals its supply. Why? Because anyone who finds him or herself with more currency than desired can simply deposit it in a bank account, whereupon it is subsequently extinguished by the Fed. 

What this chart tells us is that the demand for currency rose sharply as M2 surged, but then it declined, and now has returned to a level that is consistent with past experience. Today there is about the same amount of currency outstanding as there would have been if Covid had never happened.

 

Chart #3

Chart #3 is another measure of the demand for money: M2 divided by nominal GDP. By this measure, the demand for money has almost returned to where it was prior to the Covid era. This chart implies that the average person and average business holds about the same amount of spendable cash relative to income (nominal GDP is equivalent to national income) as they did prior to Covid. 

The Great National Money-Printing Nightmare is over, and we sincerely hope it never returns.

Chart #4

Chart #4 shows the 6-mo. annualized rate of growth of the PCE and PCE Core measures of inflation, both of which are within spitting distance of the Fed's 2% target. The Big Inflation of the 2020s is over.

Chart #5

Chart #5 shows the level of the 3 major components of the PCE deflator. Non-durable goods prices are unchanged since mid-2022. Durable goods prices are unchanged since the end of 2021, and have resumed their decline. Only service sector prices are increasing, and those are largely driven by faulty calculations of housing inflation. 

Chart #6

I've been showing Chart #6 ever since I can remember. That's because it shows that every recession in my lifetime has been preceded by a high level of real interest rates (blue line) and an inverted yield curve (red line). It was assumed to be an infallible indicator of a coming recession, but it didn't work over the past several years since the economy has continued to grow. The key difference this time is that the Fed has not caused a liquidity shortage like they did it past tightening episodes. 

real rates push dollar up, comms down wtip5

higher interest rates have done the trick

Chart #7

Chart #7 compares the level of real yields on 5-yr TIPS (not to be confused with the real yields in Chart #6, which are overnight, ex-post real yields) with an index of the dollar's strength against other major currencies. Over the time period shown, changes in real yields have reliably matched changes in the dollar's strength. In order to tighten monetary policy, the Fed must take actions that strengthen the demand for dollars, and the best way to do that is to increase the real yields on investments denominated in dollars. 

Chart #8

Chart #8 compares the strength of the dollar (blue line, same index as the one in Chart #7) with an index of non-energy commodity prices. (I exclude energy prices because they are orders of magnitude more volatile than other commodity prices.) Here we see a strong inverse correlation between the two, except over the past 4-5 years. Given the strength of the dollar, we would have expected to see much lower commodity prices. In my view, the current strength of the dollar is exercising a gravitational pull on commodity prices; over time this is likely to result in cheaper commodity prices.

Chart #9

Chart #9 shows the two most liquid indicators of corporate credit spreads. Spreads have rarely been lower than they are today, which is a strong vote of confidence in the health of the economy and the strength of corporate profits. No sign of an impending recession here. Instead, there is plenty of evidence that financial liquidity conditions are healthy and thus a recession is unlikely.

The U.S. is the King of Net Worth

The U.S. economy is the undisputed powerhouse of them all. Nothing says it better than the $170 trillion net worth of the U.S. private sector, and the fact that the market capitalization of U.S. equities is greater than the sum of all other global equity markets' market cap. The following charts provide interesting perspectives.

Chart #1

Chart #1 compares the market cap of the U.S. market against the market cap of all other equity markets. (I'm using Bloomberg's calculation, which excludes the value of ETFs and ADRs, so as to avoid double-counting.) The U.S. market cap just edges out non-U.S market cap, for the first time in the past 20 years.

Chart #2

Chart #2 shows the breakdown of the net worth of the U.S. private sector (households plus non-profit organizations). What jumps out to me is the fact that debt has increased by far less than financial and real estate assets. 

Chart #3

Chart #3 shows the net worth of the U.S. private sector adjusted for inflation. In real terms, private sector net worth has increased by 12,656% since 1952. A 13.66-fold gain in 72 years—annualized growth of just over 3.6% per year. And over the long haul, growth in real net worth has been relatively constant.

Chart #4

Chart #4 divides the data in Chart #3 by the population of the U.S. Per-person real net worth has increased by about 2.4% per year for almost 75 years. (The chart implies that the net worth of the average person in the U.S. is almost $500,000.)

Chart #5

To flesh out the implications of Chart #1, Chart #5 demonstrates that the overall leverage of the U.S. private sector has declined significantly since the Great Recession (2008-09), and is now back down to the level that prevailed in the early 1970s. This further suggests that the U.S. private sector is very financially secure on the whole. It's the U.S. government, of course that has been on a borrowing binge like the world has never seen.

Chart #6

Chart #6 details one measure of the evolution of the U.S. government's borrowing binge, which began in the wake of the 2008-2009 Great Recession. 

Chart #7

Chart #7 makes an important qualification regarding government debt. The true burden of debt is not the nominal amount (now $28.85 trillion, or about 96% of GDP), but the cost of servicing that debt (interest expense as a % of GDP). According to this latter measure, the burden of debt was much greater in the 1980s than it is now. Why? Because interest rates today are much lower.