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Positive Reactions to Job Report

Written By Briton Ryle

Posted March 6, 2015

Since hitting a new all-time intraday high a week and a half ago on February 25th, the S&P 500 has closed down 5 out of 7 trading days, and is today on its way to making it 6 out of 8.

The latest weight to be strapped to the market’s shoulders was this morning’s jobs report for the month of February, which saw better than expected figures straight across the board:

• a gain of +295,000 new non-agricultural jobs, the fourth highest in the last 12 months,

• a drop in the unemployment rate of -0.2% to 5.5%, down from 5.7% the prior month and the lowest it has been since the 2008 crisis,

• a rise in average non-farm wages of +0.1% month-over-month, +2.0% year-over-year.

How have the markets responded to this rosy employment report? Within minutes of the report’s release at 8:30 am eastern, the U.S. 10-year Treasury bond fell sharply, lifting its yield 9 basis points from 2.10% to 2.19%, with continued upward trending since then to 2.24% by 11 am.

Equities, for their part, fell with bonds, as the S&P 500 index lost as much as 10 points, or half a percentage point, within the first 15 minutes of opening, where it has remained since.

But if the employment report was so great, why the negative reaction on the markets? Frankly, the reaction was not negative at all, but positive. Here’s why.

Bond Market’s Reaction: Positive

Generally, falling bond prices ultimately spur rising equity prices. The reason, of course, is that bonds are considered safety investments whereas equities contain more risk.

Under most circumstances, capital will flow out of one toward the other depending on the level of risk flowing through the markets. When risk is perceived to be high, money generally flows from equities to the safety of bonds. Conversely, when risk is believed to be low, money will flow the other way from bonds to equities where they can be put to work generating capital gains.

That bond traders reacted to the bumper jobs report by pulling their money out of bonds means they perceive there to be less risk in the economy going forward, and as such there is less need for the safety of bonds.

Bond traders are also anticipating the strong jobs growth and rising wages – however slight that wage rise was – will force the U.S. Federal Reserve to move interest rates higher sooner than later. As it stands after this latest employment report, the general expectation is for a June rate hike, just three months away.

But if the bond market is taking the jobs report as something positive, why are equities falling? Why are stocks not on the same page? Believe it or not, they are on the same page, and the stock market’s reaction is just as positive as the bond market’s reaction.

Equity Market’s Reaction: Equally Positive

Equity traders are also anticipating an earlier move by the Federal Reserve than was previously anticipated. And interest rate rises mean slightly slower growth over the immediate term, which is why the stock market is reacting negatively today.

A rise in interest rates strengthens the buying power of the U.S. dollar, which is up today along with the 10-year Treasury’s yield. In turn, this rise in the dollar’s strength slows the economy a little in the immediate term by making American-made products and services more expensive for foreign customers, lowering the profit from exports, and increasing the cost of imports. Overall, a stronger dollar generally exerts a slowing pressure on the economy.

Hence the initial negative response on the stock market, where companies’ profits are seen being negatively impacted by a continually rising dollar now, and by future rising interest rates later.

However, over the longer term, the current pullback in equities is a positive, for it means the upcoming interest rate hike is being factored into stock prices right now. All the stock market is doing today is adjusting to a new levels based the first interest rate hike’s timing being moved a little bit closer (at least, as traders currently perceive it).

This means that when the first interest rate hike is announced, the markets will already be where they need to be ahead of time. With the bad news out of the way early, equity markets will have nowhere to go but up once the first rate hike actually takes place.

Increasing Confidence Increases Values

Overall, a strong employment report like today’s increases confidence in the overall economy by companies, investors, and even the government itself. A rise in interest rates sooner than previously anticipated would mean that the Federal Reserve is more confident in the economy’s strength than it was before. The Fed’s stepping further into the background will in turn strengthen the confidence that corporations have in the overall economy. And this in turn strengthens the confidence investors have in equities. All this confidence being evident in today’s bond sell-off.

We can, therefore, expect that once this near-term adjustment in equity prices to an earlier than expected interest rate hike runs its course – likely by the end of this month – equity prices will quickly resume their upward climb to new all-time highs, rising ever higher over the quarters and years ahead.

Remember that every time there is a change in the timing of an anticipated event – in this case the timing of the first interest rate hike by the Federal Reserve – the markets will always act immediately to price that change in expectations into their prices. But once that adjustment is finished, the markets waste no time in resuming their prior momentum based on the economy’s underlying conditions.

As it stands now, the economy’s underlying conditions are very positive indeed. The Fed is growing more confident that the economy does not need as much monetary assistance as before, the bond market is growing more confident that they no longer need as much safety from bonds as before, and equity traders are also growing more confident that the economy is still in a multi-year bull market – even if it doesn’t look like it today.

All traders are doing today is adjusting to an earlier rate hike. But once that adjustment is completely factored in, look for the resumption of one of the longest bull runs in U.S. history. Give it until the end of March, when investment funds and institutions finish rebalancing their portfolios. Then you’ll really see how today’s employment report was very good news indeed.

Joseph Cafariello