What if Jobs Growth is too much for the Fed?

Tom Sowanick, is Co-President and Chief Investment Officer of OmnivestGroup in Princeton Junction, NJ.

There is growing evidence that this Friday’s employment release could show a big surprise to the upside.

The most recent supporting data was the release of the ADP report which showed a sharp gain of 201,000 jobs for March and a revised 208,000 job gain for February. The 200,000 monthly (back-to-back) job gain is the strongest since January and February of 2006.

The four-week moving average of the weekly Initial Unemployment claims has fallen to levels not seen since July of 2008. The moving average of the claims data is corroborating the strength found in the ADP report.

It is our contention that if the monthly private sector job growth shows a gain of 200,000 jobs or more, then it will be very difficult for the financial markets not to have a strong response to the collective employment data.

From the lens of the stock investor, glee should be observed. After all, an increase in job growth means more spending power and therefore stronger economic growth in the aggregate.

Bond investors should fare considerably worse, as they begin to shift in earnest, the duration and yield curve strategies. Duration risk should be shifted to an ultra-short position, as the risk to higher interest rates will rise considerably.

However, a more important threat to fixed income investors comes from a likely flattening of the Treasury yield curve. A projected shift in the yield curve would come from re-pricing of short-dated Treasury notes to anticipate a sooner than expected shift in the Federal Reserve’s ultra easy monetary policy stance.

How soon would this occur?

It may actually already be occurring as the yield on the 2-year Treasury note has risen from 0.54 percent at the end of January to present yield level of 0.80 percent. If the job report this Friday shows strength, then a rise to 1.2 percent or higher on the 2-year Treasury note should be expected.

When short-term yields rise faster than long-term yields, a yield curve flattening condition is observed.

As the yield curve flattens, investors should move swiftly to shift out of bond ladders, short-dated bond funds, and bond mutual funds. The most important reason to move out of bond funds, including closed-end funds, is because these funds will provide absolutely NO protection as short-term rates begin to rise and the yield curve flattens.

A more appropriate strategy would be to shift out of bond ladders and into barbell strategies, which will protect against the principal loss from a bond ladder or short-dated bond funds.

If you doubt the risk of rising interest rates, then please explain why the short-dated 2-year Treasury note has already lost 0.25 percent of its principal since the start of the year. Not quite the safe asset.