The U.S. September payroll report, slated for Friday, could set the tone for the stock market. Is the U.S. Federal Reserve behind the curve? Will bad news (for employment) be bad news (for stock prices)?
It's been two weeks since the Fed's decision to cut U.S. interest rates by a half-point, and that's a decent interval to assess the financial market's reaction.
Investors should be aware of one crucial detail about market psychology. Even as the Fed offered a "commitment not to fall behind the curve" as a way of explaining its decision process, there's a widening gulf between equity market and fixed-income market expectations.
On one hand, the futures market's expectation has evolved to discounting a second jumbo rate cut at the November FOMC meeting, which is rare outside of recessions. On the other hand, the stock market is cheering the pivot in the U.S. central bank's monetary policy and the prospect of a soft landing for the economy.
It has become clear from Fed Chair Jerome Powell's remarks at the post-FOMC press conference that the Fed has shifted its focus from its price-stability mandate to its maximum employment mandate, especially in light of the tamer-than-expected August PCE report. What happens if the jobs market significantly deteriorates? Will stock prices wobble on fears that the Fed is behind the curve?
Impact of the Fed decision
The market has generally cheered the Fed decision with a risk-on reaction. The increase in stock prices is supported by a compression in risk premium and funding costs. We can see this from my monthly monitor of LBO candidates. As a reminder, I screened non-financials within the S&P 1500 for stocks that an investor could buy at 30% of the stock prices or less by raiding any cash available and borrowing against the company's own balance sheet.
Since I began monitoring the market this way in late May, the number of LBO candidates has risen to 46 from 30, despite the rise in the S&P 500. That's because funding costs, as measured by the five-year Treasury yield plus junk bond spread, has fallen.
By contrast, banking system liquidity has been flat even as stock prices rose. The latest weekly data point, which is after the FOMC meeting, is negative, though these figures can be noisy. Another quick-and-dirty real-time indicator of liquidity is bitcoin (BTCUSD). The cryptocurrency has been up marginally since the Fed's rate decision.
Moving from Wall Street to Main Street, bank credit appetite (red line) has eased but lending (blue line) is stable, though these liquidity indicators are reported with a lag.
All eyes on employment
In short, market psychology is resting on a "slope of hope" that the Fed isn't behind the curve. Much will depend on the evaluation of the Fed's maximum employment mandate. Will the weakness in the jobs market stabilize or will it weaken? Any disappointment in the jobs data could shift psychology to a fear or recessionary conditions and "bad news is bad news" for stock prices.
So far, leading indicators of U.S. employment have been weakening, but these indicators are now approaching "the boy who cried wolf" territory of false positives. The temp jobs and the quits/layoffs ratio (chart below) have historically led employment.
This latest data point comes from the Conference Board's consumer sentiment survey. The Labor Differential Index (the gap between the number of respondents who say that jobs are plentiful vs. those that say jobs are hard to get, red line) is deteriorating.
With stock investors' psychology becoming a little giddy, the risk in this week's payroll report is the prevailing consensus to pivot from bullish soft landing to bearish hard landing. While I am in the soft-landing camp, there are opposing data points available for those who look for it. As an example, the ratio of leading to lagging indicators is plunging, which is a frequent precursor to recessions.
In sum, a chasm has opened up between the fixed income and equity markets. The fixed income market expects a second consecutive jumbo half-point rate cut at the next FOMC meeting, which is rare outside of recessions, while the stock market is cheering the prospects of a soft landing.
As the Fed's focus shifts from its price stability mandate to its full employment mandate, investor expectations will depend on the strength of the jobs market. As leading indicators of employment weaken, the upcoming September jobs report could prove to be pivotal to market psychology.