Employment Is Much Better Than It Looks

The Days Ahead:

• Inflation updates and retail sales.

This Week:

• Looking behind the job numbers
• A recession warning was triggered but…
• Its author says it’s different this time
• There’s a healthy labor supply
• Explaining the carry trade
• It’s disruptive but will fade soon

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Were those job numbers that bad?

No, though you may have thought otherwise, given the markets’ reaction.

On Friday, the BLS reported 114,000 new jobs, of which 97,000 were in the private sector. The numbers  disappointed investors missed because expectations were for 175,000 and 150,000. The unemployment rate also jumped to 4.3% from 4.1%, its highest since November 2021. But digging deeper into the report tells a different story.

There’s an upswing

The graph shows headline unemployment in blue as well as underemployment in green. The first measures unemployed job seekers and the second shows part-time workers seeking full-time jobs.

There’s an upswing in both and people worry that when the unemployment rate starts rising, it quickly accelerates. As you can see from the arrows we’ve added at the bottom of each unemployment cycle,  joblessness tends to creep up and then suddenly roar ahead.

It makes sense. An employer lets some workers go, which leads to others worrying about losing their job, so they cut back on spending, sales drop and the employer lets more people go and so on in a down spiral. Sometimes these spirals are quick, as with Covid-19 when employers sent millions of people home and unemployment rose by a factor of four in two months. Sometimes they are slow as in 1990 when it took over two years for unemployment to rise by 50% to 7.8%. But the premise is the same. Slow, slow, then very fast.

Dr. Claudia Sahm knows this.

She wrote a paper in 2019 while at the Fed proposing that unemployment benefits, tax credits, food assistance programs and other “stabilizers” be paid early in the economic cycle to stop the spirals before they did more damage.

There were many assistance programs in the 2000s such as the 2009 Making Work Pay $400 tax credit, the 2011 Temporary Payroll tax Credit which reduced the tax rate from 10% to 4% for self-employed workers, and the 2012 Middle Class Tax Relief and Job Creation Act which cut social security taxes for two years. They worked but were paid out while unemployment doubled and the GDP stayed flat for three years. The payroll tax expired in early 2013, when the unemployment rate was 3% above its prerecession level and the economy nowhere near a full recovery.

What, Dr Sahm thought, if you deliver those benefits earlier? Under the existing process, she found people didn’t change their spending habits much and government payments went on for longer than expected. Indeed, Congress frequently extended programs because they weren’t getting the effects they wanted. Her suggestion was, start earlier, pay out less with more effect rather than start late, pay more with less effect.

Brilliant!

She was looking for the best time to start the programs. Too early, and they would stoke inflation. Too late, and they would fail to stimulate spending. Surely there was a better way? After all, it took two and half years for real personal consumption to recover from its 2007 lows and led to the longest post-war recession.

Her solution was to come up with a time to start benefits. Don’t use the unemployment rate, she argued, because it lags the business cycle. She was right, of course. Unemployment peaks anywhere from one month, as in 1975, to six months, as in 2003, after the end of the recession. And unemployment hits a low almost exactly the time the recession starts as it did in 1970, 1975 and 1990. So, she wrote a rule that said

When the three-month average national unemployment rate rises by at least 0.50 percentage points relative to its low in the previous 12 months….”

…we’re in a recession. So, get the payments out.

We’d point out that the paper was not a recession predictor and she never uses that phrase. She wrote it to find better ways to deliver stimulus and fiscal response. The recession predictor part of it was discovered by a few firms and given a role for which it wasn’t designed.

Anyway, the paper sat in academic circles for years, well respected but not common currency, until about a year ago when it was picked up. Now, Twitter/X’ers, pundits, Wall Street and the press love a good rule. The Taylor rule, the Beveridge Curve, Goodhart’s Law, or the Philips Curve all had their day and the Sahm Rule fits in very well. Easy to understand with rock solid back testing.

Sahm rule triggered

The trend of unemployment in the last 12 months produced a 3-month average low of 3.60% and Friday’s unemployment was 4.3%, a three-month average high of 4.13%.

The difference between the two is 0.53%, which is greater than 0.50%, and the Sahm rule says “you’re in a recession.”

Markets duly reacted

What they didn’t pay attention to was that Claudia Sahm had been saying for months that this time is different because of changes in the labor supply, especially from foreign-born workers and immigration. We should add that the BLS does not ask about legal status. It simply asks “are you employed?” If “yes” they go into the employed bucket. If “no, I’m looking for a job” they go into the unemployed bucket. There are no further questions.

The labor force has grown by 3.4 million since January 2023 while the number of people working has grown 2.8 million. That leaves around 600,000 new entrants coming into the labor market who have yet to find a job.

There’s a world of difference between someone who loses their job and ends up unemployed and someone who finishes education, training, or relocation, and hasn’t yet found a job. It’s the latter which largely explains the rise in unemployment last week and why Claudia Sahm said:

A recession is not imminent, even though the Sahm rule is close to triggering.”

The supply of new labor is great for the economy in the long-term but in the short-term it pushes up the unemployment rate and, this time, triggered the Sahm rule. We don’t think that’s a problem.

There are other good signs

We also look at “Insured” unemployment.

The blue line is the reported unemployment rate and the green line is the “insured” unemployment rate.

What’s the difference? The unemployment rate comes from the BLS calling 60,000 households of which around 25,000 respond. If you’re looking for work, you’re counted as unemployed. As of last month, 7.1 million people were looking for jobs.

The insured rate is the number of people registered with state insurance programs and receiving unemployment benefits. As of last week, 1.8 million were looking for jobs and receiving benefits. The difference between the 7.1 million unemployed and the 1.8 million receiving benefits is 5.3 million who receive no benefits of any kind. They’re just looking for a job.

The two rates usually move in tandem. But the insured unemployment rate at 1.2% hasn’t moved in over a year. This has never happened before. We think it’s because of our earlier point, that new entrants are coming into the workforce just as employers are slowing hiring. It creates a short-term excess labor supply.

Look at the long-term unemployed

We also look at those unemployed for over 27 weeks. At that point, benefits begin to expire, skills atrophy, contacts become stale and financial hardship rises. Here’s what it looks like:

Long-term unemployment has risen to 1.5 million, in line with pre-Covid-19 levels. It’s at 21% of all unemployed and well below the 30-year average of 24%.

We also look at permanent job losses. This is the number of people not temporarily laid off or furloughed. They have permanently separated from their employer. The number of permanent job losses is around 0.9% of the workforce or 1.6 million, again well below long-term averages.

Bad labor markets usually show high insured unemployment rates, job losses, high claims,  more long-term unemployment and a rise in people who no longer actively seek work. We’ve seen none of those. All this can turn, we know. But for now, the U.S. jobs market is better than it looks.

The end of the carry trade

We’ve discussed Japan a lot recently but last Friday was a shocker. The Topix Index fell 22% in two days, which was worse than the 1987 two-month crash of 21%. Some of that was the unwinding of the carry trade.

The simple carry trade

If I borrow ¥100,000 for 0.2% a year, exchange it for $714 dollars at an exchange rate of ¥140 and then invest those dollars in T-Bills yielding 5%, I will make a tidy sum of 4.8% or $34. I will then take my $748 proceeds and convert them back to yen at ¥140 and have ¥104,800 to my name. Much better than the 0% rate that a Japanese bank would have given me.

This is a simple carry trade, borrowing in a low yielding currency and investing in a high yielding currency. It’s even better if the currency yen weakens. If the yen falls to ¥160 during the year, then my carry trade looks even better, because now I swap the $748 at ¥160 which gives me ¥119,771 or a near 20% profit. I got 4.8% for the T-Bill and 15% for the weakening of the yen.

This basic trade has gone on for years with the yen as a favorite funding currency because of its low rates.

Now, let’s up the stakes

One very successful strategy was to borrow in yen for 0.2% and buy Mexican pesos yielding 11%. If I did the same trade as above but bought Mexican pesos, I would have made ¥231,000 yen or 230% between 2020 and early 2024. That’s because I received a net 10.2% in interest and the Mexican peso strengthened from MX4.3 to the yen in 2020 to MX9.35 in April of this year. That trade stomped the 92% return on the Nasdaq from early 2020 to mid-2024. The trade was so popular that the Chicago Mercantile Exchange (CME) wrote a “how to” article a few years ago.  

The currency goes the other way.

It’s all great until the exchange rate goes the other way. If, in the dollar example, we reversed the exchange rates and I bought the dollars at ¥160 and sold them at ¥140, my yen loss in now -9%. On the peso/yen carry trade, I would have made only 5%, somewhat shy of the 230% when the yen weakened.

And if you use leverage…

Many investors did these trades with borrowed money. If we take our initial ¥100,000 example above of buying at ¥140 and sell at ¥160 example, and apply a 10 times leverage, the return jumps from 20% to 97%. And if we use leverage and buy at ¥160 and selling at ¥140, my loss goes from -9% to -83%.

So just hedge it

You can hedge the exchange rate but that may get expensive. If the world is borrowing in yen and depositing in U.S. dollars, banks will know about it and will charge a hefty hedge price. Many investors chose not to hedge, which meant things could get very ugly very quickly if exchange rates moved.

How big is the carry trade?

The Bank of Japan has held rates at near zero for 20 years. Even after last week’s discount rate increase the interbank was 0.0% a year ago and even today is 0.2%. It’s hard to tell how much is bundled up in the carry trade but we know that Japanese banks increased credit to the U.S. non-financial sector (which would include hedge funds) for years and has claims on the U.S. of $1,900 billion. Japanese banks grew their credit to U.S. non-banks by 15% in the last year to $429 billion.

Many of those non-banks leveraged their yen with futures. This was another bet that the yen would decline and investors would pick up big gains along the way.

Here’s the yen short positions at the CME for the last few years.

The graph measures contracts and each is for ¥12.5 million ($80,000). Earlier this year there was a large spike in short positions with a value of $19 billion a week. The positions range from three-months to five years. We expect that any trades made back in April are sitting on losses of around 20%.

How much is in all these trades? The BIS, Fed, CME and most official sources simply don’t know. Trillions of dollars are the best answer we could find.

So why is it unwinding?

First because of this:

The yen carry trade worked as long as the blue line was going up because it meant the yen was weakening. But the Bank of Japan (BOJ) warned about the weak yen for months. Last week finally announced a rate increase with more to come. That sent the yen up by around 14% and suddenly those trades showed big losses. In the “Shorting the Yen” chart above you can also see that the traders quickly reduced their short positions. Investors wanted out.

The yen trade is bigger than the yen

Remember the yen trade was successful for years so investors used it to pair trades with other assets, the most popular being tech and bitcoin.

If three weeks ago, an investor borrowed ¥160,000,000 in yen and swapped it into $1m and bought the Nasdaq, the $1 million fell to $850,000. They then swap it back into yen for ¥119,000,000 for a loss of 25%. That loss needs to be covered so they start to sell other assets to settle up. It’s one big loop.

That’s why when people looked at risk assets like tech and bitcoin and wondered what the heck it had to do with the BOJ, the short answer was the carry trade. A 20 -year free lunch just got expensive.

When does it all end?

Soon. The world’s biggest carry trade can’t unwind without some damage. We feel many of the trades will close out in the next few months. The yen will strengthen because while the BOJ is talking rate hikes, fewer investors are willing to use it as a funding currency. Things will settle down but it’s another reminder in the world of global finance that a small change in Japan can ripple through global markets.

The bottom line

A busy week. The S&P 500 is down 7% from its record in mid-July. Volatility spiked on Tuesday but has since calmed. We’d put the sell-off down to several factors of which the carry trade is but one. The AI stocks had a mixed week, the employment numbers came in low, claims went up and one manufacturing survey came in below expectations.

There was more talk about whether the Fed will move ahead of its September meeting (doubtful) or reduce rates by 0.50% instead of the expected 0.25% (probably not). But there was no one overly alarming signal. Sometimes there’s a confluence of “only-OK” news and sometimes, as our colleague and CIO Ben Pace put it,

We may have finally moved into the “bad news is bad” phase of equity market performance”

But that will be a good phase to have behind us. Do please check out the full piece.

When we look back at this week, a year from now, we’re likely to think of it as nothing more than a small setback.

The Bank of Japan calmed things down mid-week saying that it would not make any further changes while markets were “unstable.”

The S&P 500 bounced up 2.5% on Thursday and the 10-year Treasury moved from 4.12% late last week to 3.67% mid-week and 4.01% by the end of the week.

In the grand scheme, things have settled down a lot and we’d expect them to stay that way. Seems very typical of August trading with low volumes and lightly staffed trading desks.

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Art of the Week: Natalia Goncharova (1881-1962)