Employment situation creates ebullient mood in financial markets

The perversity of (Fed) talking heads
Equity prices were generally moving higher this week, although there is no question that the biggest mover was the NASDAQ composite. Tech stocks had decreased earlier in the week and by Thursday, investors thought they should take advantage of the lower prices in anticipation of a January rally. The Dow, the S&P 500 and the Russell were moving along at slow speed. Until Friday, that is.

The most interesting market rally took place on Friday after the employment report. It seems that the stability of the jobless rate coupled with a modest gain in wages satisfied investors that the Fed would not raise interest rates suddenly this year. The most ironic part of this rally was that market players became "reassured" by the status quo - and a stronger than expected gain in nonfarm payrolls - because a Fed governor made a simple remark about the jobless rate.

Larry Meyer indicated that the Fed might be forced to raise rates if the jobless rate decreased from its current level of 4.1 percent. The initial impact of the remarks was bearish on financial markets. And as the employment report came closer to its release date, investors became increasingly more nervous. By the time Friday rolled around and the Labor Department reported no change in the jobless rate, a rally was in the cards.

No doubt, Mr. Meyer is now sorry he mentioned his worries about the jobless rate. The Fed will now be more concerned about the stock market zooming to stratospheric levels. Remember that the Fed is concerned about the "wealth effect" whereas consumers could spend more money because they feel wealthier as their stock portfolio appreciates. If Meyer hadn't stressed any particular interest in the jobless rate, the employment report wouldn't have looked so rosy to financial market participants. Now the NASDAQ composite reached a new high and the Dow (nearly) regained its previous peak.

Treasury yields are up despite Friday's rally
Fed governor Larry Meyer also spooked bond investors this past week with these remarks. Interest rates drifted higher all week - and the Treasury's long bond yield reached 6.33 percent yesterday. Friday's rally on the employment report helped bring down yields across the board. Prices were also helped by the announcement of changes in Treasury offerings. A Treasury spokesman indicated that borrowing needs will be reduced in the next couple of years and that markets would see a reduction in the supply of 1 and 2-year securities. But Friday's rally wasn't sufficient to reduce rates from earlier in the week. The weekly comparison remains unfavorable - yields are still higher.

Jobless rate unchanged; wages stable; payrolls moderate
The civilian unemployment rate remained unchanged in November at 4.1 percent. The jobless rate has remained at 4.5 percent or below for 19 months now. This strikes fear in the hearts of Federal Reserve policymakers because they believe that wage increases are just bound to accelerate. While average hourly earnings have risen more sharply since 1995, the annual growth in wages peaked in early 1998. Earnings inched up 0.1 percent in November and are 3.6 percent higher than a year ago. These figures helped fuel a rally in the bond and equity markets Friday morning.

Nonfarm payroll employment rose 234,000 in November, just a bit more than predicted by economists, but following a downward revision to the previous month's data. On the whole, payroll gains are moderate even though the 3-month moving average of the series ticked higher in November. Looking at a longer-term trend in the chart below reveals a slight downward drift to average monthly changes in the past year.

The composition of growth in payrolls was not unexpected. Service-producing industries saw the bulk of the gain in the business and health sector. Retail trade employment barely budged. But remember that it is tough to hire new employees for the holiday season in a robust economy that saw employment soar throughout the year.

Among goods producing industries, construction employment jumped 55,000 - its largest monthly gain since February. It is interesting that two of the largest monthly gains occurred in months where the seasonal naturally expects slower growth. This means that construction is healthy, but perhaps not as robust as indicated by the actual number.

Manufacturing remains the anemic cousin in this sector. Yet, given the improvement in factory orders over the past 12 months, one would have expected better employment gains in factories. The chart below shows the discrepancy that began about a year ago. This could reflect a variety of factors working together. For instance, productivity enhancements could alleviate the need for additional factory workers just at the time that labor markets are tight and skilled workers are hard to find.

The bottom-line on the employment situation? Employment conditions remain favorable. Despite a low unemployment rate, wages are not accelerating. Clearly, average hourly earnings are the worst of all possible wage measures, but at least correlate with others that show relative stability recently.

The low jobless rate is worrying Fed officials, but at 67 percent, the labor force participation rate is down from its peak of 67.4 percent, which it reached in January. This does leave some room for increased participation even if the pool of potential employees is not as large and available as the Fed chairman would like it to be.

These figures don't really change the outlook for Fed policy in the near term. The Fed almost stated point blank (in their usual cloudy manner) that they weren't inclined to raise rates at the December 21 FOMC meeting. That does leave open the question of "bias."

Home sales plunge - no wait - they skyrocket?!?
Sales of existing single family homes dropped 6.6 percent in October to their lowest monthly rate since January 1998! Clearly, this had to mean that housing activity peaked earlier this year. But wait! Sales of new single family homes jumped 16.3 percent to surpass (by 1,000) the previous lifetime high of this series reached in November 1998.

Sales of new and existing homes are substitutes. While it isn't always the case, it is generally true that existing homes are starter homes and lower-priced than new homes, which are higher priced and often for second (or third) time buyers. In any case, it is more realistic to look at the market for single family home sales in its entirety. To this end, the chart below reveals that home sales indeed peaked in June. Sales levels are high by historical standards, but drifting lower.

The bottom-line on home sales? Given the sharp disparity between new and existing home sales, it might be best not to draw a strong conclusion about the direction of this booming sector. Yet, the rise in mortgage rates over the past year (of more than one full percentage point) should eventually depress sales even in this sizzling economy. Even if home sales did peak this past summer, consumers will probably still find some reason to buy furniture and appliances for a few more months. A moderation in housing, though, will eventually trickle down to a slower rate of expenditure on consumer durable goods.

NAPM dips
The NAPM diffusion index of manufacturing activity edged down to 56.2 in November from October's level of 56.6. Despite the slight decline, it still reflects a moderate pace of manufacturing activity. Market players were probably more relieved to see a slight downtick in the prices paid index from 69.4 in October to 65.3 in November. It is interesting to note that a year ago - only 12 months ago - the prices paid index was 33.4. Of course, that was only the beginning of the run-up in oil prices.

The bottom-line on manufacturing? The NAPM and factory orders still show that manufacturing activity is moving along at a moderate pace. Most analysts do believe that increased demand for exports will help propel manufacturing activity next year even as consumer spending is scaled back moderately.

THE BOTTOM LINE
What's a Fed policy-maker to do? Economic activity continues to grow at a robust pace. Yet, apart from skyrocketing oil prices, inflation isn't a real concern. Wages have increased moderately, but aren't accelerating even with a jobless rate near 4 percent.

Most policy-makers stress that they need to be pre-emptive against inflationary pressures, but they seem to be willing to take a few chances in case a new economic paradigm has emerged in the past several years.

Fed governor Larry Meyer is the most adamant opponent of the "new economy" stressing that some key economic relationships are indeed stable. Some of the question marks surround the NAIRU (non-inflationary rate of unemployment) and the potential for further productivity growth.

The figures released this week aren't going to induce the Fed to raise rates at the December FOMC meeting just a few days before Year 2000. It is possible that they revert back to a "bias towards tightening" away from the current neutral stance. Most analysts do expect the Fed to raise rates next year. Analysts are mostly split between a February and a March rate hike.

Looking Ahead: Week of December 6 to December 10
We use the Market News Service survey of forecasts to describe the market consensus.

Tuesday
Nonfarm business productivity should be revised up to a 4.9 percent rate for the third quarter --in line with the upward revisions coming from real GDP. At the same time, unit labor costs should be revised lower and report no rise for the period. This would be friendly for the financial markets, although it does reflect "old news".

Economists are predicting that consumer installment credit could rise by $6 billion in October - reflecting healthy expenditures on consumer durables as well as regular retail spending. This would roughly match the September gain.

Wednesday
The Beige Book will be reported in advance of the December 21 FOMC meeting. Financial market players will be looking for signs of economic moderation to alleviate fears of potential inflationary pressures. Signs of slower employment demands would also be friendly news for the markets.

Thursday
Market participants are expecting new jobless claims to decrease 5,000 in the week ended December 4 from last week's 291,000. Claims remain range-bound.

Friday
Market players are looking for a 0.2 percent hike in the producer price index in November. This reflects another boost in energy prices. Excluding the volatile food and energy components, the PPI is expected to inch up 0.1 percent, less than gains of the past few months.