The Rubicon is Crossed

The unexpected decline in non-farm payrolls, the first such decline in four years, leaves no doubt that the Federal Reserve will cut interest rates at the September 18 FOMC meeting. The jobs data, which included a downward revision of 81k jobs over the past couple of months, is simply horrific and fans the most pessimistic fears. The housing market woes will undermine the US consumer, push the US economy into recession and drag down growth in much of the rest of the world.

We have consistently argued that the bar for a Fed funds rate cut was set high. We also have consistently argued that the key to the US consumer was income not housing and the key to income was jobs. The outright decline in jobs clearly fulfills these requirements.

The loss of housing related jobs accounts for the drop in non-farm payrolls, but even without it, job creation was disappointing. Direct housing-related job loss was around 33.3k. This consisted of an over 26.3k loss in residential construction, 8k loss of jobs in credit institutions and a counter-intuitive 1k gain in real estate jobs. Without those, the rest of the US economy would have added only around 29k jobs, compared with expectations for about 100k jobs.

The fact that June’s job creation was cut almost in half illustrates the deterioration in the labor market prior to the onset of the liquidity issues. The factory sector has been shedding an average of around 22k jobs per month over the past three months and the information technology sector has also lost jobs for three consecutive months. Indeed, with the Labor Department’s survey covering the week of Aug 12, it is likely that today’s report does not fully reflect the freezing up of the credit markets and the deterioration in the US housing market.

The government is not helping matters. Government lost 28k jobs in August after losing 52k jobs in July. The 80k loss in those two months ironically is thought to be the same number of families that President Bush’s FHA initiative, announced a week ago, was estimated to help.

The jobs data resolves two important discrepancies. The first discrepancy has been in the data itself. The household survey has reported an average loss of 50k jobs a month for the past three months. The non-farm payroll figures have been much stronger. The 3-month average stands near 44k, which represents a significant narrowing of the gap. The same is generally true for the ADP time series and non-farm payrolls. Temporary employment has been falling steadily and with the weakness in non-farm payrolls overall, its role as a leading indicator appears to have been validated.

The second discrepancy that is resolved by today’s data is in the realm of opinions. One camp argued the Fed did not need to wait until the economy weakened to cut rates. The other camp argued that moral hazard concerns and the fact that officials actually condoned the re-pricing of risk meant that Fed officials would be reluctant to cut rates without compelling evidence. Today’s report puts those arguments to rest.

The question now is whether a 25 bp rate cut will be sufficient. Given that Bernanke is a student of the financial crisis, he will likely see in the data the need for more decisive action. A 25 bp cut now would be disappointing. The Fed needs to get ahead of the proverbial curve. Another cut in the discount rate, perhaps even bringing it to the Fed funds rate, is a possible course, as is a larger 50 bp cut in the Fed funds rate. Weakness in the US will likely add to pressure to extend tax cuts and provide other fiscal support. Clearly, these developments are dollar negative, even if other central banks, like the ECB and BOE do not hike rates again. The German 2-year note yield has moved above the similar US yield for the first time in 3years. The $1.40 level in the euro and a return toward $2.06 for sterling seem like reasonable objectives. The risk is that this shifts the market’s focus from carry-trades to an outright run on the dollar. In this environment the yen can also strengthen, with risk of a move toward JPY110-JPY111.