NFP Review: Change of View – Fed Cut in September

Summary

• NFP missed expectations by a large margin, likely reflecting Hurricane Beryl’s impact amplified by tight credit conditions for SMEs.
• The release details show labour market resiliency (i.e., July’s weakness is likely to self-correct).
• Labour market normalization implies more negative NFP surprises ahead.
• The NFP supports frontloading of Fed easing as it shows labour market normalization well underway and its resiliency has been weakened by Fed tightening.

Market Implications

• Change of view: I now expect the Fed to cut 25bp in September (and 50bp if inflation continues slowing or the labour market weakens further – not my base case).
• Additional 2024 cuts would require more data weakness (not my base case).
• This contrasts markets pricing a 50bp cut in September and five cuts by December.

Weaker-Than-Expected Employment Release

All the key components of the July employment report were below expectations (Table 1).

Headline NFPs were 114,000 vs 175,000 expected and on a three-month basis fell to 170,000, roughly in line with the 2019 average (Chart 1).

However, the release details suggest a shock along the normalization path more than a recession.

Tighter Credit Amplifies Beryl Impact

According to the BLS, while Hurricane Beryl hit during the survey period, it should not impact NFP or household survey employment. This is because in the payroll survey, ‘employees who receive pay for any part of the pay period, even 1 hour, are counted in the payroll employment figures.’ In the household survey, ‘people who miss the entire week’s work for weather-related events are counted as employed whether or not they are paid for the time off.’

I think this statistical convention does not imply the weather had no impact on employment. First, numbers not at work because of weather spiked, meaning Beryl impacted actual work performed (Chart 2).

Second, temporary layoffs increased sharply, perhaps reflecting Beryl’s impact. A hurricane that disrupts production lowers firms cashflows. Financially strong firms can afford to keep paying their workers.

By contrast, firms with a weaker balance sheet and/or limited access to credit (typically SMEs) may have to stop paying their employees until their cashflows recover (i.e., place workers on temporary layoffs).

Relative to pre-pandemic, the correlation between numbers not at work because of weather and temporary layoffs numbers has increased (Chart 2). This suggests greater weather-sensitivity of temporary layoffs, possibly because of tighter credit conditions and/or weaker balance sheets.

Those are shown by the small business survey respondents reporting tighter credit conditions than pre-pandemic as well as by rising delinquency rates on C&I loans, especially at smaller banks that tend to lend to smaller borrowers (Charts 3 and 4).

Also, the release details suggest the July labour market weakness is likely to self-correct (assuming the US avoids another strong hurricane in August!).

July Weakness Likely to Self-Correct

The release details show a resilient labour market.

The average prime age employment to population ratio (EPOP), which tends to be procyclical, was up 10bp in July and half a percentage point above pre-pandemic (Chart 5). Black and Hispanic prime age EPOP were above pre-pandemic. This ratio tends to fall before recessions as looser market conditions result in fewer labour force entrants.

Similarly, the numbers unemployed because they newly entered the workforce were still increasing in July, signalling a tight labour market (Chart 6). This ratio typically flattens or falls before a recession as looser labour market conditions discourage new entrants to the labour force.

The insured unemployment rate did not increase unlike in typical recessions (Chart 7). This suggests the increase in unemployment involved workers who have not contributed long enough to be entitled to benefits, possibly because they are new entrants to the labour force. For instance, migrants.

The spread between the unemployment rate of minorities and that of whites, which tends to be pro-cyclical, on balance signalled a strong labour market (Chart 8). The African-American/white spread is below the 2019 average. The Hispanic/white spread is above the 2019 average and rising, but I think this reflects the large inflows of migrants at the Southern border. Those tend to take longer to find a job and are largely Hispanic.

Average and median unemployment duration increased one quarter of a week each, leaving the difference between median and average (the ‘skew’) unchanged (Chart 9). I think this small increase does not signal recession. In a typical recession, many newly unemployed increases the ‘skew.’

Part-time workers for economic reasons increased 20bp relative to the workforce but remain at the 2019 level. The gradual increase in the ratio signals normalization rather than labour market weaknesses (Chart 10).

Multiple job holders as a share of employment was up 10bp in July, a sign of labour market strength, though slightly ambiguous (Chart 11). Multiple job holders signals weak productivity and worker bargaining power since they cannot earn a living wage with a single job. Also, the numbers of multiple job holders rose in the second half of the 2010s, in line with a tightening labour market. Therefore, the rapid rise in the numbers of multiple job holders since the pandemic is likely to signal labour market strength.

The increase in unemployment triggered Sahm’s rule (Chart 12). However, as Fed Chair Jerome Powell stressed, Sahm’s rule is an empirical regularity rather than a predictive model and Sahm herself agrees.

NFP Normalization Entails More Negative Surprises

With labour market normalization, more negative NFP surprises are likely.

First, forecasters are losing their negative bias. Before the pandemic, the NFP forecast error trended to zero (Chart 13). By contrast, since 2022 the consensus has consistently underestimated the payrolls. However, the size of the forecast error is falling.

Also, the payroll survey has a 90% confidence interval of +/- 130,000. As NFP move closer to trend the risks of low prints increases, especially as NFP have become noisier since the pandemic (Chart 14).

Market Implications: Change of View – Time to Cut the FFR

At last week’s FOMC, Powell stated risks to the employment and inflation legs of the Fed mandate were balanced and the Fed would react quickly to unexpected labour market weaknesses.

By ‘unexpected’ Powell did not mean NFP prints below market expectations but rather labour market weakening above and beyond rebalancing.

July’s NFP weakness goes beyond labour market rebalancing but is likely to self-correct.

Yet, after the data, I expect the Fed to frontload its cut (i.e., start easing in September). This is because the data shows the labour market is well advanced in its rebalancing. In addition, tighter credit conditions have weakened labour market resiliency.

I think since the Fed is satisfied with the progress on inflation, this data is compelling enough for a September cut despite the associated political risks.

Furthermore, should the next NFP show continued weakness or should core PCE continue slowing (neither is my base case scenario), the Fed could cut 50bp in September.

Currently, the cuts would not respond to a recession but rather buy more resiliency against future shocks.

Further cuts would require further data weaknesses (not my base case).

By contrast, markets are pricing two cuts in September, and five by December.

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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)