Why the U.S. job market spooks investors
After an initial surge higher, shares traded lower on Friday in response to a mixed December jobs report.
Payrolls jumped by 252,000 for the month, which was slightly better than expected, pushing up the total job gains for 2014 to 3 million -- the best showing since 1999.
The U.S. unemployment rate narrowed to 5.6 percent, a sign that the job market is tightening. But wage growth slid in December, a contrary indicator pointing to continuing slack in the economy.
While divining the direct cause-and-effect of any move in the stock market is normally a futile effort, it's the drop in the unemployment rate that appears to have bothered traders. Stronger hiring is good news for working Americans, but it's bad news for the market. Why? Because not only does it keep the pressure on the Federal Reserve to end its zero percent interest rate policy, but it also jeopardizes corporate profitability as well.
At 5.6 percent, the nation's unemployment rate is near the Fed's 5.2 percent-5.5 percent estimate of long-run unemployment. It's also vnear the Congressional Budget Office's estimate of the "non-accelerating inflation rate of unemployment" -- also known as the natural rate of unemployment -- at 5.5 percent.
That means meaningful wage inflation should start materializing soon, something that could crimp corporate earnings as labor costs rise.
For now, this is being held back by the significant number of Americans that have left the workforce. The labor participation rate is down to late 1980s levels, while the employment-to-population ratio is at 1984 levels.
At its current pace of decline, the unemployment rate will drop to 5 percent by this summer, a level the Fed expected no sooner than the end of 2016. And according to Deutsche Bank, the unemployment rate is on track to end the year at 4.7 percent, or possibly lower, as the pool of long-term unemployed people dries up.
"Some will argue that the Fed will want to wait to see wage growth rising before it raises rates," analysts with Capital Economics said in a note. "But our sense is that it won't feel it needs to hold off that long and will be willing instead to trust the usual relationship between unemployment and inflation. If this is case, we may see rates rise as soon as March if the activity data continue to improve, since the unemployment rate is rapidly approaching the Fed's estimate of its natural level."
You can see this dynamic in the chart above, which shows how the number of long-term unemployed has dropped by nearly 1.2 million workers over the last four quarters.
If these trends continue, Fed officials would have little excuse to delay in starting to raise short-term interest rates for the first time since 2006. Given the outsize impact of the Fed's cheap money has had on stocks over the last seven years, the move to ratchet up rates is likely to cause turbulence.
