Why the strong jobs report puts the Fed in a bind

U.S. equities surged Friday, capping a barn-buster of a rally out of the post-Brexit lows last week. The main catalyst -- a surprisingly strong June payroll report. Large-cap stocks are now within a hair of their record highs and could be on the verge of breaking out of a three-year-long sideways crawl.

But there's a catch: The renewed strength in the U.S. labor market, and the relatively muted market and economic impact of the Brexit vote, puts pressure on the Federal Reserve to stick to its guns and raise interest rates this year. For a financial market still very dependent on the Fed's monetary morphine, this amounts to a problem.

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One manifestation of that problem is the gap between the Fed's stated intentions for interest rates this year and what investors expect it to do. Fed policymakers continue to forecast two quarter-point interest rate hikes this year. The futures market, on the other hand, doesn't expect the central bank to move on rates until the end of 2017 at the earliest.

While Fed officials have sought to keep its rate-hike options open, the bank's policy meeting in July seems too soon to take action. Watch for a possible move at the September meeting followed by another possible move in December.

For now, investors continue to completely dismiss the possibility of higher interest rates anytime soon. A "buy no matter what" dynamic has set in. If job growth slows, the thinking goes, the Fed will surely stay on hold, so buy. If job growth accelerates, that's good for the economy and the Fed is still likely to stay on hold, so buy.

Yet this ignores a long list of other headwinds: Uneven economic data, an ongoing corporate earnings recession, unknown Brexit fallout, seasonal headwinds (Sell in May?), panic bids in government bonds and precious metals, narrow market breadth as just over half of stocks are in uptrends, and trying price-to-earnings valuations.

That just demonstrates how focused this bull market is on Fed policymaking. It's no coincidence that the large moves in the stock market have been mirroring the Fed's balance sheet. When the the bank's bond buying program, or quantitative easing, ended in 2014, the upward march of stock prices stalled as well. Since then, the Dow Jones Industrial Average has struggled to stay near the 18,000 level.

What could change all of this? Undeniable evidence of wage inflation, a powerful precursor of overall inflation and a sign that the economy has hit full employment. Capital Economics notes that average hourly earnings rose at a 2.6 percent annual rate in June, the highest reading so far this year, as a variety of survey indicators keep suggesting an acceleration to 3 percent is likely over the coming months.

We will know more on the Fed's thinking when it releases its next policy statement on July 27.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.