Mortgage Rates: The Back-Up That Wasn't

At the beginning of the year, one of the frequently expressed concerns was the presumed adverse impact that the end of the Fed's massive MBS purchase program was likely to have on mortgage rates. This was a pretty straightforward argument based on the premise that supply is a major driver of mortgage rates and, in fact, yields more broadly.

Although, in classic market modus operandi, the sheer anticipation of that outcome was enough to cause a modest back up in yields prior to the expiration of the Fed's program at the end of March, the reality is that mortgage rates have declined appreciably since the beginning of the year, with the 30-year fixed rate mortgage dipping to 4.67% last week, according to this morning's data released by the Mortgage Business Association (http://www.mortgagebankers.org/NewsandMedia/PressCenter/73294.htm).




Source: Federal reserve Bank of St. Louis, MBA

The fiscal turmoil in the eurozone since the beginning of the year, an ongoing downward drift of domestic inflation, and a modest loss of momentum in the economic reports recently have all conspired to fuel a powerful rally in the bond market, driving mortgage yields lower as well. This dynamic has trampled any demand/supply-related considerations stemming from the Fed's withdrawal from the mortgage market in the second quarter.

As we have argued before, supply is a temptingly convenient factor to use in any rationale attempting to forecast the direction of long-term yields. In reality, though, it has a particularly poor track record to justify such attention. The most dramatic perhaps demonstration of the exaggerated importance that markets often attribute to supply is the fact that Treasury yields have been able to absorb a massive onslaught of supply in the last 18 months, without any signs of indigestion and remain near historically record-low levels, despite an economic recovery that has been taking hold for nearly a year now.

The advocates of supply as a key determinant of market yields always offer the caveat of "all other things being equal". The problem is that, outside the universe of academic research and computer models, those "other things" are almost never equal. In fact, changes in supply conditions typically contain the very seeds of a powerful counter-effect that neutralizes its impact. For example, the massive Treasury fiscal deficits were the direct result of a sever financial crisis and deep recession, both of which were potent forces pushing yields lower.

A similar explanation accounts for the impressive resilience of mortgage rates following the end of the Fed's purchase program; that is, the broader conditions in both the domestic economy and global market environment were a far more dominant driving force of such yields than the end of the Fed's purchase program.

Anthony Karydakis

A Cautionary Note On the Data Ahead

With the economic recovery steadily approaching a key juncture, the overall tone of the various economic releases may also change as a result, projecting an overall softer undertone that may help support the latest downward drift of bond market yields.

In the three most recent quarters, since the recovery got under way, economic growth has benefited heavily from the classic inventory cycle, which contributed 0.7, 3.8, and 1.9 percentage points respectively to GDP growth since Q3 2009; in some cases, like in Q4 2009, a faster rate of inventory accumulation accounted for 2/3 of the entire GDP growth. With the inventory dynamic slowly- but predictably- losing its fizzle, and the the boost from last year's fiscal stimulus waning by year end, a perceptible risk exists that, economic growth may be downshifting in the second half of the year, unless another sector of the economy makes up for that.

The implication of this is that pressure is building on employment growth to pick up materially in the coming months to support stronger income growth and consumer spending. The labor market statistics have been quite mixed recently, with private payrolls stalling, following a solid turnaround in the first quarter, and initial claims essentially treading water since the beginning of the year.

The relatively unimpressive picture of labor market conditions does not represent a direct threat to the viability of the recovery per se, as the latter has already entered credibly the phase of a self-sustaining expansionary dynamic. However, it does hold the key to the pace of economic growth over the next 3 to 4 quarters.

Against such a background, the importance of the ever-pivotal employment report on Friday may be greater than usual.

With a potentially sizable number of temporary census workers laid off in June, the focus, once again, should be on private payrolls, which have averaged a fairly respectable 139,000 in the last three months. Even if the nominal payroll print for the month is only marginally positive, or even a small negative, a gain in the 150,000 to 200,000 range for private payrolls would be encouraging and consistent with economic growth plowing ahead at a solid clip. However, a private payroll gain in June comparable to the disappointing 41,000 reported for May may require a reassessment of the working assumption that the recovery can sustain a growth rate in the 3 1/2% to 4% range into early 2011.

Time is running out for the employment picture to show its hand.

Anthony Karydakis

The FOMC Statement: The Day After

The FOMC's unambiguously bond market-friendly statement yesterday provided a strong boost to Treasuries, triggering a rally that has brought the 10-year yield within striking distance of the 3% mark.

In surveying the landscape today, a few comments are in order:

1) The subtle, but unmistakable, caution reflected in the Committee's assessment of the growth prospects, pushes the possible timing of the first tightening move well into 2011 (with a more specific handle on such timing being hard to assess at this distance). This is strongly reinforced by the acknowledgement in the Committee's statement that, in addition to financial market conditions that are not "supportive" of growth", inflation is also trending lower. It is critical to stress here that an outright Fed tightening move does not necessarily have to coincide with the beginning of any asset sales from the Fed's portfolio, as the latter might come first- although it has now also been pushed further out. (We will have a special article on the various pieces of the Fed's exit strategy in the coming days).

2) While fed funds futures moved quickly to remove the bulk of any risk for a Fed move this year (with only a "natural" residual of risk left in the pricing of the December contract due to ever-present, background concern about year-end distortions in the funds market), Eurodollar futures continue to reflect a moderate, steady uptrend in the 3-month LIBOR rate- the direct effect of ongoing concerns about bank liquidity. Such concerns are also fueled by the prospect of the release of the bank stress-test results in Europe at some point next month.

3) With the Treasury yield curve on course to maintain its core steepness for quite some time now, plain, old-fashioned carry trades remain very much in vogue. Viewed from a slightly different angle, this implies that any curve flattening trades, which may still have some appeal in the midst of a potential stretch of strong economic reports, should be managed with caution and viewed as purely tactical and with limited objectives.

Anthony Karydakis

Europe's Fiscal Crisis May Help the Euro's Survival

The recent fiscal turmoil and associated existential doubts about the fate of the eurozone's common currency may have actually been a particularly constructive development for the latter's future, as they have brought to the forefront the long-simmering underlying tensions with an unmistakable sense of urgency to address them head-on.

This dynamic has led to a barrage of meaningful proposals about a new, tighter framework that would allow for a better harmonization of underlying fiscal policies among the bloc's various countries and also a mechanism for closer supervision to ensure compliance with stated targets. The ECB President put forward such a plan earlier in the week (http://wallstreetpit.com/32435-ecbs-trichet-eu-governments-in-breach-of-fiscal-rules-could-lose-voting-rights), which has the tacit support of the powers-that-be within the EU. The exposition of the fault lines within the eurozone's member countries has left virtually no room for ignoring that ticking bomb that had always been identified, since the inception of the euro, as a potential threat to its long-term survival.

In the near-term, the wave of fiscal austerity measures sweeping the european countries- including, most notably, the U.K (a non-eurozone mmeber)- is meant to help defuse the immediate global financial market anxiety vis-a-vis the european countries' sovereign debt. At the same time, the longer-term plans laid out by the EU to prevent such a turmoil in the future can go a long way toward redressing the massive productivity gaps and sense of fiscal discipline in the future among the various member countries, which would strengthen the common currency's prospects.

The institutional response by the EU to the recent crisis may not be succeed in putting the recent financial market uneasiness to rest any time soon, as markets are famously demanding of hard evidence establishing the effectiveness of such measures in correcting the underlying problem. In fact, a risk does exist that, over the next couple of years, some marginal reconfiguration of the euro countries may take place, as Greece's longer-term ability to participate hangs in the balance. However, in a little noticed development last week, Estonia (with a total public debt of only a minuscule 7.2% of GDP) also announced it will be joining the euro club as of January 2011, increasing the number of participating countries to 17 (http://www.nytimes.com/2010/06/18/business/global/18euro.html).

The key point is that while a possible reshuffling of countries using the euro in the future remains a distinct risk, an outright break-up of the common currency is, by the same token, a particularly low probability outcome over the medium-term. In fact, the recent- and, mostly, ongoing- unsettling fiscal situation in the eurozone may have increased the prospects of the euro's survival down the road.

Anthony Karydakis

The Yuan Announcement and Market Reactions

This morning's dominant piece of news for financial markets is China's announcement over the weekend that it would adopt a "more flexible" exchange rate policy with the yuan. As a result, commodities and equities are rallying, on the rationale, that the likely appreciation of the yuan will lead to stronger economic growth in the U.S. (and, therefore, stronger corporate profits and demand for commodities), while the bond market is, predictably, taking a hit.

As an initial, broad, assessment of the significance of the move on the yuan, the front page article in today's WSJ ("China Eases Currency peg) is a reasonably adequate one. However, in evaluating the financial markets' reaction to the news, and the sustainability of this morning's price dynamic, some perspective is desperately required.

Despite this morning's fairly substantial rise, by nearly 0.5%, of the yuan against the dollar, the pace of further appreciation is likely to proceed very slowly, with the likely total amount of such appreciation by year end probably limited to the 4% to 5% range. Such a tightly controlled pace of the yuan's rise over the next six months or so is likely to be mostly due to two factors: a) The strong influence of the export lobby in China that will strenuously resist a more substantial pace of appreciation, particularly in an environment where their main export markets are growing at a very unimpressive pace, and b) The fact that the yuan is going to be managed against a basket of currencies, with the euro being one of its key components; if the euro's recent weakness persists, then the rise of the yuan against the dollar will have to be very limited to offset its potential further rise against the euro within the basket.

Against that backdrop, it is hard to imagine the prospect of a more flexible yuan policy ahead, which will probably lead to a further moderate appreciation next year, becoming a game-changer for the outlook of the U.S. economy over the next 12 to 18 months. Actually, the manufacturing sector, which is presumably the sector of the U.S. economy likely to benefit the most by a stronger yuan, has been doing particularly well in the last 9 months, having already become a key driving force of the economic recovery.

But the problem is not the manufacturing sector. The key challenges for the U.S. recovery over the medium-term include a still cautious pace of job creation, tight bank lending standards, any ripple effect from the fiscal turmoil in the eurozone, and the lingering drag from the housing market meltdown. Potentially stronger exports to China over that time frame are not likely to materially alter the outlook for economic growth in the U.S.

As a result, it is questionable whether the stock market's enthusiasm generated by the yuan announcement over the weekend will have long enough legs- that is, beyond a matter of a few days- to sustain a powerful rally in equity prices. It will not be before long when both equities and Treasuries refocus on the underlying realities permeating the current economic environment.

The prospect of only a cautiously optimistic FOMC statement on Wednesday -a reminder that the economic environment is still confronting a number of headwinds-, uneven economic data (with the emphasis on this week's struggling initial claims series and the magnitude of the likely decline in May's durable goods orders) may help put a brake on the stock market rally and the slide in Treasuries by the end of the week.

Anthony Karydakis

Picture-Perfect May CPI But Initial Claims Raise Some Eyebrows

The May CPI report is near-perfect in that it confirms the picture of uneventful price trends, putting to rest any lingering concern about either inflationary, or deflationary, impulses in the current environment.

The 0.2% decline in the overall index last month was the result of a 2.9% fall in the energy component- the latter largely due to a 5.2% drop in gasoline prices. The core CPI's increase of 0.1% for the month, follows a flat reading in April, and represents only the second gain in the series since the beginning of the year. In fact, in the last 6 months to May, the core CPI has been up 0.8%, while in the last three months, it has risen by only 0.4%. Year-on-year, core inflation is up 0.9%.



Source: Bureau of Labor Statistics

In the last three months, the key housing component (which represents 40% of the overall CPI) has been flat (with a 9% drop in fuel oil prices helping offset a 15.8% spike in the "lodging away from home" category), while apparel prices have declined by 4.2% and, even medical costs have risen by a relatively moderate -by the standards of that component- 2.9%.

The impressively benign price picture is hardly surprising, given the abundant amount of slack in the economy and its slow absorption rate in in the midst of a moderate economic recovery, with these factors likely to continue taming price trends over the next 12 months or so.

Inasmuch as the favorable price dynamic should appropriately be viewed as providing the Fed with ample space to delay the onset of the tightening process, it is important to recognize that the monthly inflation data are not likely to be the primary reason that will determine the timing of the Fed's exit strategy. Instead, that is more likely to be shaped by a combination of the Fed's assessment of three factors: a) the economic recovery's prospects -particularly, in the wake of the fiscal turmoil in Europe- b) the ability of the global financial system to withstand the stress that a turnaround in the U.S. interest rate cycle would entail, and c) the degree of restlessness on the ground (i.e financial markets) about the need to see that the Fed remains vigilant vis-a-vis the longer-term inflation risks posed by the liquidity currently in the system.

The 12,000 rise in initial unemployment claims in the week of June 12 to 472,000 would not disconcerting per se, given the inherent volatility of the series, but it does validate a disappointing pattern of an essentially stalled downtrend in claims since the beginning of the year. The 4-week moving average of the series is now at 464,000, not much different compared to five months ag0.

The puzzle with the behavior of claims in recent months is that it stands in sharp contrast with the significant overall turnaround we have seen in the monthly payroll data and most other labor market measures. Although, we should not expect claims and payrolls to go hand-in-hand over the short-term, one would have thought that a nearly six-month period is long enough to have allowed the two series to send a more consistent message.

One explanation for the disconnect is that the payroll data may ultimately be revised downward for the first part of the year during the annual benchmark revisions of the series next spring. Another possible, but not fully satisfactory, explanation is that the last recession has caused profound dislocations among the various sectors in the economy, where some industries continue to shed off jobs at a strong pace (therefore accounting for the still elevated level of lay-offs), while other industries are turning around in a more robust fashion, accounting for the bulk of the hiring reflected in the improved payroll data.

Today's initial claims data were for the survey week of the June employment report and there is usually an attempt to use claims as a hint for what the monthly employment report may look like. The correlation between initial claims during the employment survey week and payrolls for that month is non-existent, but, at times, some loose relationship may exist between new filings and the unemployment rate. Still, there is no meaningful hint that can be derived from today's data, as the 472,000 claims number today was nearly identical to the 474,000 claims number for the survey week in May.

The rise by 88,000 to 4.571 million in the continuing claims for the week of June 5th is also consistent with the broader theme of lack of progress on the front of both initial filings and claims recipients.

Anthony Karydakis

In Defense of the ECB

The ECB has received a considerable amount of criticism in recent weeks, as a result of its decision last month to start buying sovereign debt of some of the euro bloc's most vulnerable countries. The essence of the, at times, surprisingly sharp tone of such criticism is that the ECB has compromised its strongly prized sense of independence and is now succumbing to political pressures to pull out all the stops to contain the fiscal turmoil that has spread ominously across much of the eurozone. Furthermore, the critics argue, by doing so, the ECB is undercutting its much cherished anti-inflation credentials

The ECB's purchases of sovereign, euro-denominated, bonds have been fairly aggressive so far, with a total of over EUR40 billion of such purchases having settled in the first three weeks of the program. ECB watchers expect the program to reach EUR 60 to 70 billion in the foreseeable future. Although no official breakdown is available regarding the issuing countries of the bonds purchased, it is widely believed that the bulk of those purchases involve Greek debt.

The criticism of the ECB on this issue has been unfair and, by most reasonable standards, widely off-the-mark.

Despite the ECB's much publicized single mandate of keeping inflation in the eurozone "below, but close to, 2%", it is always the unspoken, but paramount, responsibility of any central bank to preserve the integrity of the financial system in the country/zone of its operation in periods of pronounced stress. That is exactly what major central banks have always done under such circumstances in recent history, with the most dramatic such episode being the 2008-09 global financial crisis.

In response to the crisis, both the Fed and the ECB took a number of unprecedented measures, some of which were going directly against the traditional concept of a central bank as the ultimate inflation fighter. It was precisely in that context that the Fed engaged in a program of purchasing $300 billion of Treasury securities, crossing a line that was nearly unthinkable in the past- namely of debt monetization; and this, before including the massive program of purchasing mortgage-backed and agency securities, totaling $1.4 trillion. During that period, the ECB conspicuously refrained from purchasing any sovereign debt of its member countries and limited itself to purchasing a total of EUR 60 billion of "eligible covered bonds" in the open market.

That the ECB is coming now under fire for moving aggressively to help extinguish the fire ignited by the fiscal turmoil that has threatened the integrity of the euro, is a serious misreading of its true mission. Meeting the inflation target "over the medium term" is certainly critical, but, first, Mr. Trichet needs to keep the eurozone in one piece to be able to conduct monetary policy with the objective of meeting his single mandate on inflation. There would be no role for the ECB to play if the eurozone collapsed. In fact, it would be negligence, bordering on serious monetary policymaking malpractice, for the ECB to refrain from taking significant special measures in the midst of the bloc's intense fiscal crisis.

As far as the potential inflation repercussions of the ECB's recent program of sovereign debt purchases, the risk appears quite limited. The HICP (Harmonized Index of Consumer prices) for the eurozone is running at 1.5% in the 12-month period to April and is expected to tick higher to 1.6% after the release of the May data tomorrow (6/16/10). Although it does represent an appreciable upturn compared to its low point six months ago and it is still comfortably below the 2% target. Besides, it would be unreasonable to believe that the projected modest pace of eurozone GDP growth in 2010-11 of about 1.5% represents a risk of generating any inflationary impulses.

Mr. Trichet's anti-inflation credentials have been impeccable in the last six and a half years at the helm of the ECB. Inflation is running close to its lowest since the inception of the euro and is lower than the rate prevailing in most legacy countries prior to the creation of the common currency. If anything, he has often been criticized in the past for being overly committed to the ECB's official inflation target, often at the expense of growth in the eurozone and with a steady bias toward keeping monetary policy a notch or two tighter than circumstances might have warranted at various points. (After all, the intense criticism he received for being in a tightening mode in early July 2008 -having raised the ECB's overnight rate by 25 basis points to 4.25% in just two months prior to the Lehman affair- is still fresh).

The ECB and Jean-Claude Trichet have built enough capital with their strong anti-inflation credentials over the years that they should not be viewed with suspicion as to whether they are compromising their commitment to price stability with their bond purchase program in response to an exceptional set of circumstances that they have been confronted with. They deserve more credit than that. Doing otherwise simply highlights the sad reality that markets have, indeed, very short memory.

Anthony Karydakis

The Real Problem With An Early Fed Tightening Move

The Kansas City Fed President, Thomas Hoenig, has been an increasingly vocal proponent of the view that that the Fed should no longer offer financial markets the promise of zero short-term rates for an "extended period" of time- having dissented in each FOMC meeting since the beginning of the year over the use of such language in the official statement. In recent days, and on two separate occasions, he has upped the ante by arguing that the Fed should raise the fed funds rate to 1% by the end of summer. (http://www.reuters.com/article/idUSN0810408120100609)

Mr. Hoenig's rationale is a fairly straightforward one: short-term rates are at unustainably low levels, setting the stage for inflationary complications over the long run, and the economic recovery has already gained sufficient traction to withstand a series of modest steps that would signal the beginning of the normalization process for rates. Furthermore, according to that view, monetary policy is meant to be anticipatory and leaving rates at zero for too long would risk planting the seeds for the next bubble that could destabilize the financial system again; therefore, it needs to act soon before any such clouds appear on the radar screen.

A limited number of other Fed officials also appear to be showing signs of uneasiness recently about the possibility that the Fed may be creating some risks by delaying the beginning of the exit strategy; Philadelphia Fed President Plosser and St. Louis Fed President Bullard have made some "soft" comments along those lines in the last few weeks.

On the face of it, it is hard to disagree with Mr. Hoenig's argument on this issue. The U.S. economic recovery is moving forward in the context of a broader, albeit uneven, turnaround in the global economy and the financial system. Although the latter is still confronted with seemingly never-ending challenges (the latest one being the sovereign debt market turmoil), it has admittedly come a long way since the heady days of 18 months or so ago. Against such a backdrop, how damaging a relatively modest increase of 75 to 100 basis points in the fed funds rate- or beginning the unwinding of the Fed's massive portfolio- can be to the economy or the financial system?

This view, though, does suffer from a serious flaw in that it vastly underestimates the potentially disproportionate negative reaction that financial markets will show to concrete actions signaling that the interest rate cycle is turning. The Fed's raising of the fed funds target, as well as the interest it pays on bank reserves, by as much as 100 basis points in a series of quick moves over the next couple of months (the latest time frame proposed by the Kansas City Fed President) is likely to lead to a major selloff in the bond market, as participants, in typical fashion, will front run the prospect of further tightening by the Fed. After all, the funds rate would still be at an extremely low 1% and, by most people's standards, the concept of normalization of short-term rates would envision a road toward a funds target in the 3% to 4% range.

The bulk of such a selloff in response to the Fed's first shot across the bow would be heavily skewed toward the front end of the market, causing a severe flattening of the yield curve, which, in turn, would undercut one of the key factors that have contributed to the healing and return to relative profitability of the banking system in the last several quarters. In view of the recent doubling of the 3-month Libor rate to over 50 basis points- a direct reflection of the anxiety percolating in the European banking system due to the sovereign debt situation- an abrupt further increase in short-term rates that would be set off by any Fed tightening can prove dangerously destabilizing for the global financial system in the current setting.

Inflation in the U.S. and eurozone remains at extremely low levels and, given the unimpressive forward momentum of the economic recovery in both regions, it is unlikely to show any upturn over the next 12 months or so. With regulatory financial reform in the offing, both in the U.S. and Europe, and the threat of a default by some countries (the debt of which is largely held by European banks) lurking in the background, the global banking system is finding itself again at a key juncture.

None of this suggests that the Fed should remain sidelined out of fear of potentially disturbing the fledgling economic recovery and delicate balance of the banking system. Short-term rates are indeed unsustainably low and the gradual unwinding of the Fed's balance sheet may indeed start taking place later this year, before any other overt tightening policy action is announced.

But it is imperative to recognize that the view Mr. Hoenig has been openly advocating has a major hidden risk, as it is not about just a series of modest steps that would still leave the funds target at a historically very low level- therefore unlikely to be very consequential to the broader environment. A series of modest such rate hikes by the Fed will translate into a potentially massive back up in yields that would far exceed the actual Fed action. And for that to be absorbed relatively smoothly (that is, with only a reasonable amount of noise), without throwing everything up in the air and creating renewed sources of anxiety and turmoil, the Fed needs to be highly confident that the time is ripe for such action.

The inevitable change in the FOMC's language from the current "extended period" wording will be the first test of the markets' ability to handle stress over the next few months, on the account of a perceived risk of real tightening down the road. But, arguing that the overall economic and financial environment is ready at this point to accept the blow of actual Fed tightening over the next couple of months is a proposition somewhat disconnected from the realities on the ground as to how markets function.

Anthony Karydakis

Is Global Growth Slowing After All?

The presumption that the Eurozone fiscal crisis will be a pivotal factor that will have an adverse effect on global economic growth ahead has been widely adopted by financial markets in recent weeks. While such a potential risk cannot be dismissed, we remain skeptical as to how significant its negative effect on the U.S. (or, global, for that matter) economy will ultimately be.

The OECD, for one, is not so sure. Two weeks ago, it released an upward revised estimate for economic growth in its member countries for 2010 and beyond compared to its previous forecast issued in November 2009. In its latest forecast, it now expects growth to rise by 2.7% this year versus 1.9% in its previous, "pre- Eurozone fiscal crisis" estimate, while it has also revised higher its growth estimate for 2011 to 2.8% from 2.5% previously.
(http://www.oecd.org/document/9/0,3343,en_2649_201185_45303817_1_1_1_1,00.html)

The OECD's upgraded forecast, while acknowledging the growing risks stemming from the instability in sovereign debt markets, is based on the reality of rising global trade flows. This trend is, to a considerable degree fueled by the sharp fall of the euro since late last year and the ongoing strength in growth in China and other key emerging market economies.

Even in the eurozone, which has been squarely in the eye of the fiscal storm recently, it is still not clear whether the net effect of the fiscal austerity measures sweeping its member countries will have a bigger contractionary effect on growth than the benefit to growth derived from the boost to the bloc's exports to other non-euro countries- courtesy of the weaker euro. The latter effect, is in fact, quite powerful, as the euro has not declined by over 20% since late last year against the U.S. dollar alone but also against the yuan, allowing eurozone exports to gain competitive ground globally at the expense of China.

The news coming out of Germany (the world's second biggest exporter) in the last two days highlights that ambiguity best. Factory orders surged in April by 2.8%, after an upward revised 5.1% increase in March, driven by a 5.5% spike in export orders from countries outside the euro area. Also, just this morning, Germany's industrial production numbers showed a solid gain of 0.9% in April, suggesting that the economic recovery in the biggest eurozone economy (and a global exports powerhouse) is moving forward at a good clip.

The single most important channel via which any protracted sovereign debt market instability can influence the U.S. economic recovery is the sharp pullback in equities and its possible adverse effect on consumer spending in the months ahead. Again, the uptrend in personal spending is unlikely to be derailed by a 10% or so erosion in the equity market- particularly if this proves to be a relatively short-lived affair. Moreover, a partial offset to the adverse impact of equities on household spending is provided by the recent sharp increase in mortgage refinancing activity- again, the direct result of the eurozone' fiscal crisis having led to lower market and mortgage rates lately.

Risks to the prospects for the U.S economic recovery do exist and the extend to which the sovereign debt situation deteriorates requires close monitoring in the months ahead. However, in the heat of the moment, there is at times a tendency to underestimate the resilience and complexity of the U.S. economy, and this is a risk we also need to guard against.

Anthony Karydakis

May Employment Report: Underwhelming, But Not Ominous

With the emphasis traditionally placed on the headline nonfarm payroll number, today's employment report can only be described as disappointing. The census-bloated payroll increase of 431,000 in May included only a modest 41,000 gain in private payrolls compared to gains of 218,000 and 158,000 in April and March respectively. On such grounds, the Treasury market's initial reaction to the report is fully understandable, and, on some level, perhaps justified.

However, a more dispassionate look at the specifics of the data still points to an ongoing underlying improvement in labor market conditions, albeit at a pace that, overall, still falls short of expectations for this phase of the economic recovery.

Some of the silver lining, that merits attention in the May report includes:

a) A 29,000 increase in manufacturing jobs, which brings the cumulative gain in that category in the last 5 months to 126,000. This is fully consistent with the strong showing of the employment component in the ISM recently, which confirms that the sector is moving ahead at a solid clip.

b) The gain in the workweek for all employees continues to rise, edging up again to 34.2 hours, a classic precursor to more hiring ahead. The series has been showing a steady uptrend since late last year.


Source: Bureau of Labor Statistics


c) In the household survey, the number of persons employed part-time for economic reasons (the so-called involuntary workers) fell by 343,000 last month to 8.8 million. A downtrend in this series should be viewed as a direct reflection of an improving labor market landscape, as employers are increasingly more willing to employ full-time workers in the midst of a turnaround in the overall economic climate.


The drop in the unemployment rate to 9.7% last month from 9.9 in April, is of little material importance, as it essentially returns the series to its Q4 2009 level, and it was mostly the result of a somewhat counter-intuitive fall in the number of unemployed re-entrants to the labor market by 286,000 in May.


Without downplaying the disappointingly slow pace of net new hiring in the private sector, it appears that, apart from the notoriously noisy nonfarm payroll number itself, there is little reason to conclude from today's report that the recovery is in danger of stalling. Such conclusions would represent an overly hasty take on a set of data that tend to be more nuanced than the disproportionate degree of attention paid to a single number (that also enjoys a well-deserved reputation for being the subject of, at times, extreme revisions in subsequent months).

Based on the broader set of economic indicators released in recent weeks, there is little reason to scale down appreciably our earlier "penciled-in" forecast that we are likely to see average monthly private payroll gains in the vicinity of 200,000 in the third quarter.

Anthony Karydakis