Did the Markets Make a Mistake On Friday?

The markets may have made a mistake on Friday as they did not appear to appreciate the dovish implications of the September Employment Report and a dovish speech by Fed Vice Chair Stan Fischer on Friday.  Stocks fell, Treasuries sold off initially and then ended little changed, and the dollar rose on the day.   To the extent that these moves reflected a failure to analyze the data/speech correctly, there could be reversals this coming week.  It is possible, however, that the markets were still fixated on the fall-out from Brexit and developments regarding Deutsche Bank.  These two items, along with the Presidential election and Q316 earnings, are likely to be the most important factors overhanging the markets in the next few weeks.

The Report was dovish for two reasons:

1.   The uptick in the Unemployment Rate to 5.0% -- thanks to a higher Participation Rate -- was exactly consistent with the factor cited by Yellen as the reason the Fed did not hike in the prior week's FOMC Meeting.  That is, the labor market capacity expanded to allow for sold job growth without inflation.

2.   The 0.2% Average Hourly Earnings was on the low side of the increase implied by calendar considerations.   This supported the idea that wage inflation is well under control and suggests that many of the new jobs are low-productivity/low-wage.

Fischer devoted a speech to acknowledging (by explaining) the possibility that the "natural" rate of the funds rate is close to zero.   This is the first speech I recollect him making that raised dovish implications for monetary policy.  The speech can be found on the Fed's website.  Moreover, on Sunday, Fischer voiced little concern that the Fed was at risk of waiting too long to hike.

The failure of the markets to react appropriately to these two events might be explained a number of ways:

1.  The markets focused on the solid Payroll gain, even though it was well below the average pace seen in prior months this year (156k m/m versus 181k).   The few Street economists/analysts I read seemed to emphasize this part of the Report.  This focus was incorrect, however, given the uptick in the Unemployment Rate.

          a.  To be sure, this September Employment Report is not the last word on the labor market this year, but it is ahead of the November FOMC Meeting.   The October and November Reports will be released ahead of the December meeting.

2.  Weakness in the Pound and, to a lesser extent, the Euro dominated the FX market and exacerbated fears of significant economic problems stemming from Brexit.

           a.  As I wrote in a prior blog (June 26), a way to understand Brexit is that it entails a loss of value-added from the association for both the UK (and to a lesser extent) the Euro area.   Both now have to work harder to maintain the same standard of living -- and the boost to exports and import substitutes from their weaker currencies is the way the markets act to allow that to happen.   This means that it should be no surprise that UK and Euro area real-side economic indicators improve -- contrary to the expectation of a recession by most economists.  But, their weaker currencies could hurt US net exports.

3.  The regulatory problems with Deutsche Bank continued to hold back stocks. 

           a.  The demand by the US Department of Justice for a large fine for alleged misdeeds in 2007-08 is an example of policymakers aiming for a goal with the unintended consequence of harming economic growth -- a factor behind the sluggish recovery since 2009 (see my blog of September 27).