Post-Jobs Data Thoughts--Vulnerabilities Abound

There is no doubt that the US jobs data is disappointing. The debate among the talking heads is the degree of the disappointment.

One of the key themes we have been hammering is that the shift in the incentive structure of interest rate differentials has swung against the dollar. We have focused on Euribor and the 2-year US-German differential. In response to the jobs data, US rates have fallen further and have spark a rally in European debt instruments as well. Interest rate differentials are moving further against the US. Equities are tumbling, but remain higher on the week still.

The terms of the debate have shifted. Calls for fiscal consolidation have lessened. Now there are more calls for the government, including the Fed, to do more to support the economy.

Following the jobs data, the first issue is the implications for the US economy and Fed policy On the margin, it may increase speculation that the FEd will recycle the proceeds from the maturing and early paydowns from its MBS holdings back into the MBS market. While we think it would do very little material good given the low level of interest rates and spreads now and could further aggravate the illiquidity of the MBS market, it is a distinct possibility. The Fed typically does this with its Treasury holdings so treating its MBS portfolio the same way is not really a significant step, though it is not clear how that would support the economy.

The second issue is the implication for other countries. Here Canada and Mexico have been hit. Canada had its own disappointing jobs and PMI (IVEY) today, which has gone a long way to negate the positive impact of the M&A talk, wheat story and Fin Min comments that helped lift the Loonie yesterday. The Mexican peso is under pressure today primarily as a response to the implications of the disappointing jobs data.

Earlier today both Germany and the UK reported unexpected contractions in June industrial output figures. With fiscal tightening around the corner in most euro zone countries (this year is really more of a Greece, Spain, Ireland and Portugal story), short-term interest rates rising (Euribor made new 12 month highs this week) and the euro and sterling's appreciation, it does not seem reasonable to expect Europe to maintain the kind of momentum seen in Q2. This also raises the issue of decoupling in the emerging markets. Surely the market has taken on board that the US economy has downshifted. It has not yet reached that conclusion about Europe. The recent PMIs suggest that the region has decent momentum at the beginning of Q3.

Meanwhile the markets love affair with emerging markets has continued. China issues many key economic reports next week. Most of the data is expected to be consistent with a modest slow down. One of the key tail risks in the financial markets would seem to be that global investors become more cautious about emerging markets. Many do not seem prepared for that. Since much of the EM buying appears to be funded with the dollar, a setback in the emerging markets might actually more more supportive for the greenback than may be appreciated.