August 5, 2005 Jobs & the Yield Curve

The bond markets are continuing to decline as investors become more convinced that the Federal Reserve and the Bank of Canada will be increasing interest rates. The consensus view is that the economy in the US is growing at a pace that has the Federal Reserve concerned about inflation pressure building.

The recent non farm payroll report is supporting that view, the US economy saw 207,000 jobs created in July well ahead of the forecast of 180,000. The growth in employment has been quite lackluster over the past year or so and this report may be indicating that the economy has been growing faster than forecast in the second quarter. The Federal Reserve has been steadfast in its view that interest rates are still too accommodative and that more rate increases will be required to bring the economic growth down to a sustainable level.

The problem is that the bond market does not believe the Feds view on economic growth and has been forcing long bond yields down over the past few months. The investors have been consistently forcing down the yield on long bonds while the Federal Reserve has been just as consistently increasing short term interest rates. This combination has flattened the yield curve over the past few months and if the trend continues the US yield curve will move to an inversion by the end of the year.

An inverted yield curve has an almost flawless ability to predict a recession. Over the past 20 years the yield curve has become inverted seven times six of those times the economy was in a recession 6 to 9 months later. If the Federal Reserve continues to increase interest rates over the next few months there is very little doubt that the economy will suffer next year.

The situation in Canada is not quite as clear, the economy is growing but not it the traditional areas. The manufacturing sector has been held back over the past couple of years by a much stronger Canadian dollar and that has led to a reduction in the number of jobs created in this sector. The manufacturing sector has traditionally been a driving force in the Canadian economy.

Stats Canada released the Labour Force Survey for July which reported that only a very disappointing 5900 jobs were created for the month. The main weakness was in the manufacturing sector which lost 26,000 jobs the third decline in the last four months. The construction sector which has been a pillar of strength in creating jobs also reported a decline of 26,000 jobs. Jobs are being created in retail trade, health care, telecommunications and agriculture.

The Bank of Canada has been suggesting that interest rates will have to increase in the future. This employment report may cause the Bank to hold off on a rate increase until later in the fall. The lack of job growth in sectors that have traditionally been high income sectors will not have a strong impact on the amount of consumer demand in the economy which would then lead to inflation pressure.