We Have a Situation

Originally posted at Briefing.com.

With the release of the minutes for the April 26-27 Federal Open Market Committee (FOMC) meeting, the Federal Reserve floated a trial balloon about possibly raising the target range for the fed funds rate at its June 14-15 FOMC meeting. Well, that trial balloon got popped by the Employment Situation Report for May, which created quite a situation for the capital markets.

Probably Not

To be fair, there wasn't a lot of conviction ahead of the report in the idea that the Fed was going to raise the fed funds rate in June.

Prior to the release of the Employment Situation Report for May, the fed funds futures market placed only a 19% probability of a rate hike at the June meeting. The probability of a rate hike at the July 26-27 FOMC meeting, however, stood at 59%.

In the wake of the aforementioned report, the probability of a rate hike in June has been reduced to just 6% while the probability of a rate hike in July has been slashed to 35%.

While we're at it, we might as well note that the probability of a rate hike at the September meeting has been cut to 51% from 66% and that the probability of a rate hike at the November meeting has dropped to 54% from 68%.

Listen to Technician Gary Dorsch: Fed Confident US Economy on Steady Ground – Prepared to Raise Rates

That leaves the December 13-14 FOMC meeting as the going favorite in the fed funds futures market for when the Fed will next raise rates. The probability of a rate hike at that meeting currently stands at 69%.

This goes to show just how disappointing the Employment Situation Report was deemed to be by market participants.

That line of thinking, though, wasn't exclusive to the fed funds futures market. It bled across capital markets and manifested itself in knee-jerk reactions that led to a sharp decline in the US Dollar Index, a significant rally in the Treasury market, a quick drawback in the bank stocks, and a pop in the high dividend-yielding utility sector.

Now, let's get to what all of the fuss was about.

Payroll Growth Rolls Over

The real outcry revolved around the extremely weak payroll growth in May and the downward revisions for the prior two months

Specifically, nonfarm payrolls were reported to have increased by just 38,000 in May. March was revised to 186,000 (from 208,000) and April was revised to 123,000 (from 160,000), meaning employment gains in those two months were 59,000 less than previously reported.

Private sector payrolls increased by just 25,000 in May. March was revised to 167,000 (from 184,000) and April was revised to 130,000 (from 171,000).

With the May report, the three-month average for nonfarm payroll gains dropped to 116,000 from 181,000 in April and it stands well below the three-month average of 203,000 seen in May 2015.

Read Chad Syverson Busts the Labor Productivity Mismeasurement Thesis

The stark slowdown in job growth runs counter to the very encouraging initial claims readings that have been seen for some time now.

Weekly initial claims have remained below 300,000 for 65 straight weeks and are indicative of job growth closer to 200,000 per month.

The incongruent dynamic here suggests employers are comfortable with existing staff levels but are reluctant to add to their payrolls. The reasons why are debatable, yet a heightened level of uncertainty about the outlook is probably right up there.

Scared Away

With the market cognizant that the Federal Reserve was reluctant to pull the rate-hike trigger when nonfarm payroll growth was increasing to a point where it was averaging 200,000+, it isn't willing to buy the idea that the Fed will pull the rate-hike trigger in June, seeing that nonfarm payroll growth is now decelerating and averaging closer to 100,000 per month.

Granted the Fed's line of thinking is that payroll growth between 100,000 and 125,000 is enough to keep the jobless rate steady, but with other aspects of the May employment report being less robust as well, the Fed is very likely to remain in its tracking mode.

That means the Fed will forestall a rate hike until at least the July meeting, if not longer, especially with that uncertain "Brexit" vote lingering on June 23.

That might sound ludicrous to some with the unemployment rate falling to 4.7% in May—the lowest since November 2007. The added awareness, however, that the drop in the labor force participation rate to 62.6% has played a big part in that improving unemployment rate, and that a whole lot of workers are still having difficulty finding full-time employment, will probably be enough to scare the Fed into not scaring the market with a June rate hike.

By the way, the U6 unemployment rate, which accounts for the total unemployed plus persons marginally attached to the labor force and the underemployed, was unchanged in May at 9.7%.

A Wrestling Match

One bright note in the Employment Situation Report for May is that there was some stickiness in average hourly earnings growth, which was up 0.2% month-over-month. That left average hourly earnings up 2.5% year-over-year, which was in-line with the average for December through April and near the best levels has seen since late-2009.

A pickup in average hourly earnings growth should bode well for consumer spending, assuming, of course, consumers don't get spooked by the weak payroll report and elect to save more than they spend due to anxiety about the job market.

The market can only wait and see if that anxiety shows up in future reports for retail sales and personal spending.

In the meantime, it will continue to wrestle with the question whether the market is primed to break out or break down.

What It All Means

The thought of the Fed keeping rates lower for longer certainly hasn't hurt this market through the years. If anything, it has been its main support system.

The Employment Situation Report for May, then, could ultimately be turned around as a positive factor for the market. That thinking is rooted in the understanding that it has helped drive both the dollar and long-term rates lower.

Read also Why Big Job Misses Are Likely to Continue

Lately, there has been some burgeoning concern that a strengthening dollar will get in the way of the economic and earnings rebound the market is desperately waiting for in the second half of the year. A weaker dollar will bolster earnings prospects for US multinationals and boost the competitiveness of US exporters. It could also mitigate some of the concerns linked to the ability of emerging markets to repay dollar-denominated debt.

A drop in long-term rates, meanwhile, simply perpetuates the view that stocks have better return potential than lower-yielding Treasuries.

These perspectives have washed in and out of favor as the economic data has turned. It has been an exhausting condition and arguably a key reason why the stock market has basically traded sideways since the end of 2014.

It's the situation market participants are stuck with because it is the situation the purportedly data-dependent Fed has created.

The Employment Situation Report for May will give the Fed plenty to think about, but if the Fed holds true to its sheepish form, it will likely prove once again to be all talk and no action—and the stock market may just like that.

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Chief Market Analyst
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