By James Saft
(Reuters) - The Federal Reserve is watching job creation, but investors will be better off keeping a wary eye on profits and bond yields.
Yields have risen in the past two months, while corporate profits may be on the slide, both of which should undercut job growth and exercise a powerful influence over the Fed's next move.
While the evidence from the first week of corporate profit reporting season is mixed, profits and margins look to have weakened in the second quarter as companies struggle with lower spending by governments and a difficult environment of falling inflation.
At the same time, evidence of an improving jobs picture, as well as dovish statements (now partly taken back) from the Fed have convinced markets that they are on a path towards 'normal' interest rates. In other words, higher rates.
Benchmark 10-year Treasury yields rose by more than a percentage point from early May to early July, topping out above 2.71 percent.
That move, in and of itself, is bad news for both the U.S. and the global economy, as is shown by Fed Chairman Ben Bernanke's efforts to partly row back on remarks which convinced investors he'd soon begin scaling back the central bank's purchases of bonds. Rates rocketed higher in May after Bernanke's remarks convinced many that relatively encouraging jobs figures were setting the stage for a tapering of bond purchases as soon as September.
"Our conclusion is that these yields are unsustainable and, if they last long enough, will sow the seeds of their own destruction by weakening (and possibility terminating) the domestic and global expansions," economist David Levy, of the Jerome Levy Forecasting Center writes in a note to clients.
Levy argues, convincingly, that higher yields, if sustained, would hurt the domestic economy in at least three ways. First, by crimping the recovery in housing, as higher mortgage rates are felt and the marginal buyer turns away from purchases.
Second, rising yields will cap stock markets' gains, which in turn may encourage higher savings rates. Higher savings, while a good idea and much needed in the long term, will slow growth now. Finally, higher yields will hurt exports, both by hitting growth in emerging markets and by driving the dollar higher, making U.S. products less attractive.
IS JOBS GROWTH SELF-SUSTAINING?
Other than a view on future Fed policy, why does the market believe market rates will rise over the coming year? Much stock is given to what have been genuinely encouraging jobs figures, which have been on an unmistakably upward slope in recent months. With the Fed having placed a strong emphasis on achieving a 6.5 percent unemployment rate, as against 7.6 percent today, before it raises rates, it is easy to conflate job growth today with rising rates tomorrow.
There is a tendency too to see jobs growth as self-sustaining, and indeed there are solid links between jobs and household creation and auto purchases.
Still job creation follows GDP growth, which itself tracks profits. With profits moderating it becomes hard to see the jobs recovery as self-sustaining.
That's especially true given the frankly bizarre behavior of corporations during the most recent recovery in profits, which took them to nosebleed territory. Basic economic theory holds that companies, which on the whole like to make more money, invest in new production when their margins and profits are high. That simply didn't happen this time round, which is perhaps why job growth only really became solid once housing began to bubble again.
There is disagreement about why companies failed to invest when times were good. Some believe it's because they recognize and fear the vulnerability of households and governments with shaky balance sheets. Others, notably economist Andrew Smithers, argue that piratical executives have hijacked companies and won't invest because they know that they will soon jump ship.
Either way, if companies didn't invest as profits and margins rose, it is very hard to see them doing it as they fall.
To be sure, profits so far this reporting season have been mixed, with banks such as JP Morgan, Wells Fargo and Citigroup providing bright spots.
David Levy uses a metaphor his economist father was fond of, that an economy in transition is like a train rounding a bend: the caboose can still be going one direction while the engine is already going another.
It is unclear whether we are in transition, but profits are usually the engine, and this time particularly, interest rates will help to decide how fast the train goes.
Based on the last two months, that is not faster.
(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)