Rates will continue to rise despite disappointing payrolls

Friday's release of the June non-farm payrolls data was clearly disappointing with weak data across the board. Non-farm payrolls rose 112k vs. market expectations of 250k and our bullish call of 270k. The NFP gains in April and May were revised downward by 35k instead of the recent trend of upward revisions to prior data. The unemployment rate held steady at 5.6%.

But is it all so bad? No. The NFP numbers are highly volatile with strong seasonal factors. Also, there were some anomalies such as no jobs created in the construction industry despite a housing boom and very low job creation in the services sector despite strong results in the ISM Non-manufacturing employment surveys.

The labor market recovery is on track, and the anecdotal evidence such as help wanted ads continue to point to hiring. However, the market reaction to the data was swift. There was a strong rally in the back end of the Treasury curve (30-year bond price rallied 1.2 pts), and the short-end of the curve tightened by 14bps to 2.50%. The USD index fell nearly 1 pt to 88, going through the early June lows. Any pullback in expectations for Fed rate hikes is likely to weigh on the USD.

Note that the June payrolls result does bring the market closer to our Fed rate view. In our most recent publication on the US ("US: Fed to react gradually to strong growth and rising inflation" from June 12), we argued that the market was pricing in too aggressive monetary tightening for 2004-05. Since wage pressures are a key reason for broad-based price pressures, the June payrolls result is consistent with a slower pace of tightening than the market had been expecting. We continue to look for a 25bps hike in August and 2.0% fed funds by year-end.

Before the next FOMC meeting (August 10), we will have July payrolls and June inflation numbers. Only very weak numbers on both fronts would lead the market to change the view of a 25bps rate increase to no change. In fact, an upward revision to June's payrolls is a distinct possibility as that was the case for most prior numbers. On the other side of the coin, much higher than expected inflation data such as 0.4% for the core CPI/PCE could revive the debate about 25bps or 50bps hikes at the August FOMC meeting.

Equally interesting to the economic implications of the weak June NFP result is the political implications. Surely the result was not a plus for President Bush, and spokespeople for the campaign of Senator Kerry were on the news right after the number highlighting how weak the jobs figure was. Clearly that was just political posturing, but if the jobs numbers do not print higher than June's in the months ahead, that could be a serious problem for the Bush re-election.