Breech: Fed Wrong, Trim Bond Holdings

May 06, 2014

Beware the coming bear market in bonds, as the Fed appears to be wrong about the weak job market, James Breech argues.

Neither the Federal Reserve nor the market is currently anticipating any inflationary wage pressures to build that might prompt a reaction from the Fed for at least another year.

But what if labor market conditions begin to tighten earlier, as the latest U.S. government jobs report may be telling us?

Clearly, the Janet Yellen Fed would acknowledge that it has made a mistake and would begin to tighten much earlier and more rapidly than the bond markets currently anticipate.

At Cougar, we’re already positioned for that moment to come.

But before explaining why we disagree with the Fed and how investors should prepare for the day when the Fed changes its tune, readers should know that we regard the bond market as increasingly perilous and the only fixed-income exchange-traded fund we own is the iShares MBS ETF (MBB | A-98).

Yellen Views

In her speech to the Economic Club of New York on April 16, Yellen expressed her view that the falling unemployment rate belies slack that persists in the job market. In other words, she believes people are, for now, giving up on looking for work, which means they’re no longer counted as unemployed because they’re out of the pool of people actively looking for work.

There aren’t yet any signs that the U.S. central bank is keen on rethinking that view in the wake of the latest U.S. government jobs report. And neither are financial markets, which are telling us for now that they generally agree with the Yellen Fed insofar as bond yields are dropping, not rising.

For the record, those data showed that the economy added a more-than-expected 288,000 jobs in April and that the employment rate dropped to 6.3 percent.

Yellen believes the decline in the labor-force participation rate is cyclical, which is to say it’s linked to the slow recovery following the market crash of 2008-2009.

The 10 million Americans who remain unemployed, plus the 6 million Americans not included in the ranks of the unemployed who want a job but have not actively looked for work in the past four weeks are thus critical of the Fed’s view that inflationary pressure emanating from the jobs market remain largely at bay.

As I noted above, we disagree with Yellen. At Cougar, we believe this decline in the labor-participation rate is far more structural and related to an aging population. People are dropping out of the labor force because they’re retiring or they’re too old to work.

In fact, this trend is almost 15 years old, as the chart below clearly shows, and suggests that employers are likely to find it increasingly hard to locate and hire qualified candidates for a host of skilled positions.

If that’s true, then there’s almost certainly going to be increasingly upward pressure on so-called unit labor costs, implying that the bond market is going to be reflecting inflationary pressures in the form of rising bond yields.

The Fed, based on its view of the labor-force participation rate, believes that deflation continues to be more of a threat than inflation.

So let’s look at the chart:

Labor_Participation_Rate_1945_-_2014

 

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