And Then There Was One

Payrolls: Enjoy It While It Lasts

Friday’s nonfarm payroll number blew economists out of the water. December came in 50% stronger than the consensus and was the highest in nine months. The strength of the data caused some banks to change their forecast to zero rate cuts from the Federal Reserve this year. Fixed income markets were looking for two 25-basis point rate cuts in 2025 but dropped it to only one after the report. Investors expect that single cut to occur in the year's second half. The question remains whether this marks the start of an extended period of strong labor demand or is merely a statistical blip.

We are concerned that this report is harmful for policy making. There are two things that bother us:

·       The seasonal factor the government applied to adjust December payrolls was so flattering that it greatly inflated the headline number. This pattern repeats last year’s, which caused the December 2023 data to be revised down sharply. Downward payroll revisions have averaged 30,000 over the past two years, and we expect dramatic revisions to Friday’s number.

·       The household unemployment survey has ballooned by almost 600,000 over the past year. There is an entrenched weakness reflected in the JOLTS survey that job losers still cannot land a new job. Lackluster hiring will continue to push unemployment higher.

The danger in Friday’s number is that the Fed will again get comfortable with a soft-landing mindset based on a single datapoint. The economic glow from payrolls can change with Wednesday’s CPI inflation data, but for now, Friday’s report pushes the central bank further away from cutting rates. This change may be happening at just the wrong time.

Buzzer Beater?

Timing is everything. The U.S. stock market is coming off two consecutive outsized annual gains, and if history is a guide, the third year of a bull market will disappoint. It tends to be positive but pales in comparison to the first two years. Supporting this view is the Presidential election cycle: the first year is positive but is the weakest across the four-year cycle. The bulk of gains come in the final two years of a president’s term, and the last cycle’s back half was no exception; 2023 and 2024 were great for investors. There is also an elevated risk of a 10% or greater correction in year three, and based on a typical one-year seasonal cycle, it is most likely to take place in Q1 or Q3 (the latter being the infamous September-October bearish window). Given the uncertainty surrounding inflation and the interplay between tariffs, immigration, deregulation, and the budget deficit, expecting a volatile year does not take too much imagination.

The current rally is already longer than one-third of all bull markets since 1945. However, Jim Paulsen points out that if you look at the top one-third of all bull markets, they are more durable and exhibit strong returns in years four through six. Therefore, if equities stay supportive through their third anniversary in October 2025, we could expect extended gains on the horizon. The Presidential cycle certainly backs Paulsen’s assertion for solid stock gains during the final two years of the Trump administration in 2027 and 2028.

As the clock ticks down, this bull's longevity may depend on whether investor demand appears and buys the dip. A key factor for equity demand is the relative attractiveness of the bond market. With lower expected stock returns, the closer fixed-income investors push 10-year yields toward 5%, should push capital into bonds and out of stocks.

China Says Gòu Le!

No mas, basta, however, you want to say it, the People’s Bank of China (PBoC) has had enough. Enough of the bond rally driven by investors seeking a haven from the deflation that has depressed stock and real estate prices. Banks have been reluctant to lend, and they are adding to bond buying demand as they park their cash. These capital flows have contributed to bond yields making record-breaking lows, prompting the PBoC to abruptly suspend its own bond buying program.

The problem is that this surprising move makes the PBoC look like it is losing control of its own bond market. Central banks normally welcome lower rates because they are supportive of growth. However, we believe China wants to slow the drop in yields for two reasons. First, there is a risk of a bubble forming where yields could rise sharply if buyers in this crowded trade panic and exit all at once. A sharp jump in yields is the opposite of what the central bank wants. Second, the government wants to slow the depreciation of the Yuan. The widening gap between Chinese and U.S. interest rates has caused the Chinese currency to depreciate 5% since September. The PBoC is trying to control the speed of depreciation by removing a pillar of bond demand by suspending their purchases. Their hope is to contain the yield gap.

Ironically, the more the Yuan falls, the less sticker shock U.S. investors will experience from increased Chinese tariffs. A 10% tariff is only half as painful if the currency falls another 5%, supporting U.S. demand for Chinese goods. China can ill afford a sizable drop in export revenue, so its central bank should not try to push against beneficial market forces.

What to Look for This Week

1. Tuesday, January 14  at 8:30 a.m. E.S.T. December Producer Price Index. Core PPI has been 3.4% for the last two months, the highest level since March 2023. As usual, we are concentrating on the Final Demand Less Food, Energy and Trade Services series. It has risen from 2.5% to 3.5% in the last year and has been sticky near 3.5% since July. Any break above would be a significant leading indicator for higher inflation.

2. Wednesday, January 15 at 8:30 a.m. E.S.T. December Consumer Price Index. Core CPI has been 3.3% for the past three months, and the Cleveland Fed is forecasting yet another 3.3% print. England, France, Germany, and Spain report their CPI data earlier in the day.

3. Wednesday, January 15 at 11:00 a.m. E.S.T, New York Fed President John Williams speaks. He will be the first Federal Open Market Committee (FOMC) voting member to speak after the inflation data and employment are known. FOMC voter Goolsbee also speaks an hour later. The Beige Book for the Jan 28-29 FOMC meeting is released at 2:00 p.m. E.S.T., but it should have little market impact as expectations are locked for no change in rates at that meeting.