Good News is Bad News

Stocks opened higher this morning, extending a week-long rally. The Dow is up 220 points and the S&P 500 is up .4%. Commodities are trading higher as well, partly because the dollar is a little weaker. WTI crude oil is holding above $79/barrel, and gold is up another 1% (now almost 13% year-to-date). The bond market is mixed, with longer-term Treasuries and junk bonds down modestly in price, but short-term issues moving a little higher. All of these moves—stocks, bonds, commodities—can be explained by one report from the Dept. of Labor (see below).

Initial jobless claims—or first time filings for unemployment benefits—spiked last week to 231,000 from 209,000 in the prior week. That’s the highest tally since August. States reporting the highest initial claims were New York (+10k) and California (+4k). As an aside, Bloomberg Economics estimates the minimum wage hike will cost the state about 30-90k jobs in the near future. Because of its high frequency (weekly) this report is often viewed as a warning sign for coming deterioration in the labor market. And this morning the financial news media was quick to point out that it might be signaling an increase in layoffs and therefore economic weakness.

That said, the report wasn’t shocking enough to turn our heads. After all, the total number of people receiving unemployment benefits as a percentage of the workforce held steady at just 1.2%. And a separate report tallying layoff announcements—the “JOLTS” report—did not indicate a spike in layoffs. We acknowledge some softening in the demand for labor, but it’s too early to jump to any conclusions.

Back to the market reaction. Why would the hint of rising unemployment cause the stock market to jump, the dollar to fall, and short-term bonds to rally? It only makes sense through the lens of the Federal Reserve’s likely reaction to the news. The Fed has kept short-term interest rates at high or “restrictive” levels for some time. And thus far the economy has shrugged it off. In fact, growth has been so strong that when inflation stopped falling the Fed delayed plans to begin reducing rates. They believe the economy can continue to handle this anti-inflation medicine; maybe they don’t need to lower rates.

Until a couple of weeks ago, this judgment seemed perfectly reasonable. We’re now starting to wonder. In recent days the ongoing flow of economic data have turned less optimistic. Citigroup’s US Economic Surprise Index, measuring the degree to which data are beating or missing expectations, began trending lower several weeks ago and is now in negative territory. Today’s Dept. of Labor report certainly didn’t change that trend.

That the economy is slowing cannot be lost on the Fed, which prides itself on being “data dependent.” The investment community knows this, and guesses that slower growth may force the Fed to begin lowering interest rates soon. Fed Chair Powell acknowledged this possibility in his last press conference. It’s not that investors are truly worried about the economy falling into recession, but rather they want to see lower rates because stocks and bonds tend to perform better when rates are moving from high to moderate levels. Slowing growth could give the Fed cover to begin cutting rates.

So here we are—bad news for the economy is good news for stock and bond markets.