Talk about a fly in the ointment!

The worst thing that could have happened for the Fed was yesterday’s payroll number, which increased by 528,000 in July.

First, non-farm payrolls are a very backward-looking number because employment changes occur late in economic cycles …

What’s more, hourly earnings have been averaging 5.2% year-over-year increases for the past three months and are trending aggressively higher. That is causing serious inflationary pressure. 

Finally, the labor force participation rate dropped again and is nowhere near pre-Covid levels, as it has been pointing down for months.

Jerome Powell will have no choice but to continue his aggressive tightening policy, but under the hood this number may actually end up causing an even worse recession. 

Here’s why (and what to watch for next week). 

The Jobs Report Was Too Strong

This is not what the Fed needed.

Powell was just saying at the FOMC meeting that he wants to engineer a slowdown in growth and the labor market. 

Here are a couple of lines from his statement …

We think it is necessary to have a growth slowdown … We also think that there will be, in all likelihood, some softening in the labor market conditions. And those are the things we expect, and we think they are probably necessary to get inflation back down on the path to 2%. 

A lower participation rate, coupled with higher hourly earnings, makes the labor market even tighter, supporting further wage growth – and inflation. 

As you can see in the chart below, since 1960, every time the Fed tightened to, or above, neutral, the economy entered recession. Notice how the neutral rate (light blue line) is turning up, requiring further tightening 

Payrolls Impact on the Markets

Treasury interest rates are up .20% in the short maturities and .10% in the long maturities. 

The all important 2-year/10-year curve is now inverted 41 basis points. A curve this inverted is not the sign of a healthy economy …it means the economy has been choked by higher rates and is on the verge of needing stimulus not tightening.

This inversion is especially bad for banks because they hold overnight money and lend long-term, so there is literally no profit margin.

Let’s take a look at the curve compared to SPDR S&P Regional ETF (KRE):

The stock market rally has dragged KRE higher as the curve has inverted, causing a major divergence from the norm. 

Now, the next Fed meeting is not until after the Sept. 16 expiration, so a bearish option play in KRE has a high probability of success as the market may correct heading into it.

Traders bullish overall on the stock market could combine a call credit spread on SPY or QQQs and pay for a put spread in KRE. 

In this environment when higher rates will cause defaults, banks suffer especially into the fall, which is seasonally very tough on stocks and bonds.

Bring It Home 

Overall the market absorbed the hit of more aggressive tightening very well. First support for SPY (410) held and June’s high on QQQs (314) held also. 

Next week we should get the signing of the CHIPs and Inflation Reduction bills. It may provide a buy-the-rumor/sell-the-fact opportunity. 

This would be an ideal setup to execute on bearish strategies like the KRE idea.

We will pick it up then in Power Income Trader – join us!

Have a great weekend and as always …

Live and Trade With Passion My Friend,

Griff