April’s much-analyzed U.S. payroll data were rather interesting, less because of the data than because of the reaction. While the April number was the strongest in 27 months, what was amazing was the market reaction, with both the bond market and the gold price rallying on the day of the announcement. U.S. nonfarm payrolls increased 288,000 for April, up from the 203,000 increase of March and the biggest monthly gain since January 2012. Yet the ten-year Treasury bond yield declined 3 basis points on May 16 to 2.58%, the lowest level since February 3, while the gold bullion price rose 1.2% to $1,300/ounce.

This was the opposite of what was expected and raises the question of why markets reacted that way. The tentative answer seems to be that investors were finally paying more attention to the still-anemic wage growth and the declining labor participation rate than to the overhyped focus on payrolls. For, while the payroll data were positive, the data published the same day on wages and the participation rate delivered a different, more bearish, message. As we said before, the average hourly earnings growth for all private employees slowed from 2.1% year on year in March to 1.9% year on year in April—the slowest growth rate since March 2013. The labor force participation rate fell from 63.2% in March to a four-month low of 62.8% in April (see Figure 3).

Figure 3. Labor Force Participation Rate, 1985-April 2014

And for 47 of the past 48 months more unemployed Americans have left the labor force than have found a job (U.S. Bureau of Labor Statistics, Form A-38).

All this is evidence that conditions remain tough for the average American. In this respect it is worth reiterating that deflationary risks remain real, given the lack of income growth and the continuing overhang of debt. On this point it is worth noting that inflation data would be even lower were it not for rising rents. Thus, U.S. core CPI inflation rose to 1.8% year on year in April. But if shelter costs, which account for 41.6% of core CPI, are excluded, then inflation ran at only 0.8% year on year for the past three months (the lowest level in almost ten years). This reflected the fact that shelter CPI inflation was 2.5% in April, down slightly from March’s 2.8% (see Figure 4).  The continuing low level of CPI less Shelter are a potential warning that we are approaching a zero inflation rate and may tip into deflation.

Figure 4. CPI, 1995-April 2014

Rents are rising because many ordinary Americans cannot afford the equity down-payment to obtain a mortgage that is required by banks post-crisis. This means growing demand for rental housing, which is also one reason the buy-to-let boom, drove the housing recovery in 2011 and 2012. As has been noted by many analysts, this has been a housing recovery led by investors, not end users. This is best demonstrated by the continuing failure of the new purchase mortgage application index to pick up more convincingly. But it is also suggested by the fact that the housing recovery has been led more by prices than activity. In a normal recovery property market, activity should lead prices. The evidence suggests that developers are not convinced of any buying power outside the investor class.

To take a contrary interpretation of the data analyzed above, assume “escape velocity” has been achieved.  To some analysts who hold this view, the improving economy will arise because the growth of average hourly earnings suddenly gains traction despite the perceived “slack” in the labor market. This gain in average hourly earnings would confirm the view of those who argue that America’s declining labor force participation rate is structural rather than cyclical. This particular turn of events would put Federal Reserve Chair Janet Yellen on the defensive, since she has been espousing the “cyclical” view of the labor market.

If the contrary view is correct, the often anticipated monetary tightening will be more preemptive than is currently anticipated, to continue on with our “structural” hypothesis, there would more than likely be acceleration in monetary tightening expectations as the “consensus” suddenly concludes that the Fed is “behind the curve.” Still, the flurry of belief in the revival of “animal spirits” will be relatively limited, since it will take only a quarter or two for the pickup in interest rates to slow the economy materially because of the overhang of debt. At that point investors will be forced to focus again on the continuing underlying deflationary reality.

All of the above, however, is just a hypothesis of how things might turn out if wage growth suddenly gets traction i.e., it will be a late-cycle symptom just as it was in 2006 when growth of average hourly earnings suddenly picked up.

In this article we have examined a number of economic indicators to gauge the robustness of the U.S. economy. The evidence suggests the economy has not attained “escape velocity” and at best is stalled in a tepid recovery. And a tepid recovery does not bode good or evil for yield chasing. It does, however, increase the uncertainty—i.e., risk—of holding lower-rated debt.

In our next article we will look at stock and bond market movements in our search for clues on yields and their related risk premia.

[1] “Searching for Yield, at Almost Any Price,” New York Times, May 1, 2014

[2] Escape velocity is the point where the U.S. economy pulls away from the relative statis it has exhibited for a year or more now.