Why I Think Interest Rates Are Too Low

Friday's U.S. payroll report came as a relief, as total headcount surpassed expectations, and there were large upward revisions for the prior months to boot. This should keep the Federal Reserve on track for rate hikes in 2022 and perhaps indicate that there's more underlying strength to this economy than we thought.

A Welcome Rebound

As I said, this is a nice rebound after two disappointing months. I'm not surprised. All along we knew demand for labor was red hot, and each of the last two months had some one-off issues that made the overall number look worse than it was. Moreover, the 235,000 in upward revisions now puts a very different spin on those prior months.

That being said, we are probably nearing a transition point. For much of 2021, the economy was adding jobs at an unheard of pace. So far in 2021, total payrolls have grown by 0.40% on average per month. We are probably nearing an end to these massive recovery gains. The 2013-2019 pace was only 0.14%. So if we assume that's the right pace for a "normal" but healthy economy, 0.14% equates to about 200,000 monthly job gains. I think we should expect to slow to that pace in the coming months.

While this transition may feel like a slowdown, it really reflects an economy that is growing near the edge of its capacity. In other words, it is a sign that the economy is running hot.

Labor Supply Remains Tight

Speaking of capacity, Labor Force Participation (LFP) continues to be range bound. Compared to 2019 levels, about 3.1 million people have dropped out of the labor force entirely, neither employed nor looking for work. Despite stimulus running out and schools restarting, people just aren't re-entering the labor force.

In his post-FOMC remarks, Federal Reserve Chair Jerome Powell cited a few reasons why he thought LFP wasn't recovering, including the difficulty of getting child care and worry about catching the virus. He said these impediments should fall away in the coming months and labor supply will improve.

Powell could certainly be right, but I'm not so sure. It appears most of the labor market dropouts came from workers who had been earning relatively low wages before the pandemic. Consider that more than 100% of the total decline in labor participation has come from people with less than a college degree.

Source: Bureau of Labor Statistics

On its face, you'd think lower wage workers would be least able to afford periods of income interruption, if in fact these wages were supporting the household. Hence, I suspect in many cases the wages of labor force dropouts were not supporting the household. This was supplemental income that the household doesn't absolutely need. Perhaps it was a retired person earning a little extra money, but now that person is content to live off a pension. Or perhaps a former two-income home where one partner got a raise and now the other partner is staying at home to save on childcare costs.

I understand why Powell would prefer to couch the labor supply situation the way he did. It helps him buy time before having to hike rates. However I think it more likely that the tight labor supply conditions we see now will persist throughout this expansion. What you see now is probably what you are going to get in terms of labor conditions.

What Does This Mean for the Fed?

Powell has incrementally lowered the bar for "full employment" in recent months, including this week where he said that the economy could reach full employment by the middle of next year without citing any particular metric. I read that as suggesting that if job growth merely continues to be solidly and consistently positive in the coming months, the Fed will consider the employment side of their goals met.

In one sense, that means these employment reports are a bit less important, i.e., the timing of the first Fed hike is probably entirely dependent on the persistence of inflation. No particular unemployment rate and/or total job gains really matters, assuming that employment is still growing.

However, in another sense, continued employment growth is crucial for investors. What really matters for the pricing of longer-term rates is not so much when lift-off occurs, but actually how many times the Fed will ultimately hike. For example, if the Fed ultimately raises their target rate to 1.25% and goes no further, the 10-year Treasury is probably cheap at 1.50%. Whereas if the Fed is going to ultimately get to 2.5% or 3%, the 10-year yield is way too low. In these examples, it doesn't matter much whether the first hike happens in June or December or into 2023. It is really about how high the Fed can hike before doing damage to the economy.

The underlying strength of the economy, and degree to which that strength causes inflation pressure, is what will determine how high fed funds peak during this cycle. Job growth will be one easy way of measuring that underlying strength. At this point, stimulus checks have mostly been spent and the economy is almost fully reopened. If labor demand remains red hot, it would increase the odds that fed funds will peak at a higher level than the last cycle. I remain optimistic that will be the case, and hence, I'm inclined to think interest rates are too low.

At the time of publication, Tom Graff was Short 5-year, 10-year and Ultra 10-year Treasury bonds.