MBS Day Ahead: Reaction to NFP is Going to Surprise Lots of People

The inspiration for today's notes comes--as it sometimes does--from something I read and wholeheartedly disagreed with.  The piece in question isn't bad, and it might not even be wrong.  It represents the counterargument to my thesis on Fed rate hike prospects, which is that the Fed has seen enough data to hike and only abstained in September due to the unexpected and intense global market volatility in late August, and then abstained in October to give markets a chance to come to terms with that reality. 

In fact just yesterday, Atlanta Fed President Lockhart let that cat out of the bag when he said the Fed's intention with the October statement was to shift market expectations regarding the rate hike.  Later that evening, St. Louis Fed Pres Bullard went even further, saying the Fed is already considering the challenge of explaining the recent slowing in labor markets as a natural part of the recovery and that the hike is a given based on the progress that's already been made.  In other words, last week's announcement was a courtesy nudge  so that markets wouldn't be caught so off guard by the apparent 180 as to react with unhealthy volatility.*

So what did the Fed do?  Something they haven't done since 1999.  They called out the December meeting right there in October's text.  They frosted that cake by ignoring the weakness in the last jobs report and instead upgrading their assessment of the economic situation.  It was unabashedly bullish and I would bet very heavily on the fact that the transcripts that become available in 5 years time will show the Fed had specific conversation about hiking in December being a given.

That's my camp.  This is the other camp.

It's important to know about this other camp.  You might even be in it, and that's OK.  There won't be any way to know who's right unless the data arrives in just the right way to best test the hypotheses.  That would involve an exceptionally weak report today.  From there, this other camp would assume that the Fed is more likely to hold off on hiking rates.  They'll ultimately be wrong, but there are enough of them that trading levels could temporarily benefit if the report is weak enough.

But be aware, we're talking about something excruciatingly weak in order to change the thinking at the Fed.  Along with the Bullard comments that came in while I was writing, he also says that job growth of 100-125k is adequate--a similar sentiment to several recent Fed speeches, including Bernanke earlier this week (who said it would only take 100k). 

Beyond all that, it's just way too soon to consider the past 2 months of NFP weakness as marking some sort of troubling turning point.  We've seen the troubling, threatening turning points in NFP in the past and this is definitely not that.

In examples A and B, notice how the shorter averages (blue and green) swoop back down toward the longer term average (orange) a few years after the initial thrust of the recovery.  No such swoop in the current recovery.  Moreover, job growth hasn't even turned any noticeable corner as far as that 2-yr average is concerned.  The 6 month average looks nominally noisy and nothing more.  Could this change?  Sure!  But it won't change with one report, so it won't change today!  Therefore, there's really nothing short of a sub 100k print that is going to cause any major reassessment of the bigger picture. 

The truly interesting scenario would be to see how much bond markets sold off in the case of a big beat.  Let's say NFP comes in over 200k and unemployment drops to 4.9.  If that doesn't produce an epic sell-off, you'll know that no one really thinks the Fed is still looking at data, and all the recent trading has simply been an adjustment to last week's announcement.  Bottom line, if they don't hike in December, it won't be because today's NFP is super weak.  So NFP will only hurt us if too many traders have had their heads in the sand and STILL (mistakenly) see the Fed as data dependent.   (To be fair, they are data dependent, but they've already seen the data they need to hike in December).

*True story: I occasionally write the morning notes the night before.  I typed the sentence about markets not getting caught off guard and a few minutes later, the following wire hits my screen: "RTRS - EXCLUSIVE-BULLARD SAYS GUIDANCE ABOUT A POSSIBLE DECEMBER RATE HIKE WAS NEEDED IN RECENT FED STATEMENT TO "REEL" BACK INVESTORS WHO DOUBTED CENTRAL BANK'S PLANS."  So... yeah...  What he said!