The US yield curve flirted with inversion again. The US economic outlook remains solid and so we believe Fed easing expectations are overdone and see US rates at the long end rising further. Annual benchmark revisions to the jobs data Friday will not derail ongoing strength in the US labor market, which ultimately supports our strong dollar call.
The global economic impact of the coronavirus remains unknown. There have been some tentative signs that the spread of the virus is slowing, but it’s way too early to sound the all-clear. Despite the uncertainty, we continue to believe that the US remains well-positioned to deal with a slowdown in global growth and trade since the economy is relatively closed. This renders the US much less vulnerable to a scenario of slower global growth.
Yet the US 3-month to 10-year curve has flirted with inversion this past week. It has moved back to positive slope this week as the US data came in strong. At +8 bp today, the curve is the steepest since last Tuesday. The US economy is nowhere near recession and we think the curve should continue steepening in the coming weeks. As the curve has steepened, Fed easing has gotten pushed out. While the rates market still sees a high chance of the Fed easing this year, WIRP suggests a 25 bp cut is now fully priced in by November vs. July last Friday.
US jobs data Friday will be the next key reading for the economy. Consensus sees 163k jobs vs. 145k in December. Overall, the clues suggest another strong number. Weekly jobless claims for the BLS survey week containing the 12th of the month came in at 223k, the lowest since the October survey week. The employment component of ISM manufacturing PMI came in at 46.6 vs. 45.2 in December. Today, ADP came in at a whopping 291k vs. 157k expected, while the employment component of ISM non-manufacturing PMI came in at 53.1 vs. 54.8 in December. The jobs data will also be closely watched for the final benchmark revisions for 2019 that will be reported at the same time (see Brief History Lesson below).
A BRIEF HISTORY LESSON
Monthly jobs numbers are derived from the Current Employment Statistics (CES) program. This is also known as the payroll or establishment survey. It is a monthly survey of around 142,000 businesses and government agencies that represents nearly 700,000 worksites across the US. From this sample, the CES derives its readings on economy-wide employment, hours worked, and earnings. As the methodology suggests, this survey excludes agricultural workers and the self-employed. Anytime a small sample is used to infer the characteristics of a much larger body, there are bound to be errors. Enter the annual revisions, which are benchmarked to actual state tax records and meant to give a more accurate picture of the job market.
From the BLS: “Each year, the Current Employment Statistics (CES) survey employment estimates are benchmarked to comprehensive counts of employment for the month of March. These counts are derived from state unemployment insurance (UI) tax records that nearly all employers are required to file. For national CES employment series, the annual benchmark revisions over the last 10 years have averaged plus or minus two-tenths of one percent of total nonfarm employment. The preliminary estimate of the benchmark revision indicates a downward adjustment to March 2019 total nonfarm employment of -501,000 (-0.3 percent).”
The Bureau of Labor Statistics released its preliminary annual benchmark revision for its jobs data back in August. Looking at the previous ten years of BLS benchmark revisions, eight have been downward and two have been upward. Taking the absolute values, the average revision size is 255,000 and the average revision percentage is 0.2%. Bottom line: the preliminary 2019 revision is about twice the average of those seen in the previous ten years. In the past, the final benchmark estimate has typically been close to the preliminary reading. If so, there will be significant downward revisions, but these would not derail what we see as ongoing strength in the US labor market.
January ISM manufacturing PMI and auto sales came in firmer than expected Monday. After the big miss for Chicago last week (42.9 vs. 48.9 expected), the ISM reading was particularly reassuring, as it rose to 50.9 vs. 48.5 expected and 47.2 in December. This was the first reading above the 50 boom/bust level since July. Yesterday, factory orders rose 1.8% m/m vs. 1.2% expected. Today, ADP jobs and ISM non-manufacturing both surprised to the upside.
Next week will see more major US data. January CPI will be reported next Thursday, followed by retail sales and IP Friday. January auto sales came in at a better than expected 16.84 mln annualized rate vs. 16.70 mln in December, which suggests that the US consumer is still alive and well.
US economy remains strong. Advance Q4 GDP came in last week at 2.1% SAAR and that strength appears to be carrying over into 2020. The Atlanta Fed’s GDPNow model now estimates Q1 GDP growth at 2.9% SAAR, up from 2.7% previously, while the NY Fed’s Nowcast model estimates Q1 GDP growth at 1.6% SAAR. While these early reads are far apart and subject to significant revisions, we are clearly far from recession and the Fed is right to maintain steady rates for now and assess how the outlook unfolds in 2020.
The Chicago Fed National Activity Index remains the best indicator of US recession risk and it came in lower than expected at -0.35 for December. However, the 3-month moving average still fell to -0.23 from -0.31 in November and was the lowest since August. Note that a value of zero shows an economy growing at trend. Positive values represent above trend growth, while negative values represent below trend growth. The January reading will come out February 24, and the 3-month average should improve significantly as the -0.74 reading for October drops out.
Bottom line: We believe US recession risks this year are very low. Although the rates markets have started to adjust, we believe they are still overestimating the downside risks to the US outlook. From our view, the backdrop remains dollar-positive as the US continues to stand out as desirable in terms of global investment. DXY has broken above last week’s high near 98.188. Next target is the November 29 high near 98.544. If it gets there, then we think a test of the October 1 high near 99.667 is in the cards. This suggests the euro should test the October 1 low near $1.0880, while USD/JPY should make new highs above 110 and perhaps test the April 2019 high near 112.10. US equities should also continue to gain from solid economic growth and earnings. The US yield curve should continue to steepen, though we suspect rates at the long end will be capped by the lack of significant price pressures.
Of course, this is all predicated on the continued economic expansion in the US. If the facts change and the economy slows sharply, then the Fed will have no choice but to acknowledge a “material change” and shift its expected rate path. But for now, the market can count on steady rates from the Fed in 2020.