NFP surprise, USD weakness and employment theories

Dow Jones ended the day on Friday with a 230-point gain. Nikkei is also trading in green in the opening today. Euro, GBP are trading with good gains against the USD with 1.2150 and 1.4010 respectively. Dollar Index is at its lowest level since end of Feb. US 10-year yields are trading at 1.59, it had dropped till 1.47 on Friday. The emerging market currencies like ZAR and INR are showing smart gains against the Dollar. An optimistic risk on kind of mood. Even when virus numbers increase at alarming pace in India, we will check the reason behind this optimism today. It has something to do with NFP.

On Friday the most awaited data print i.e. the US NFP number came out. The actual print of 266k was starkly less than the market expectation of 1 million job additions. Generally, whenever there is such stark difference between the expectation and the reality one needs to question if there is some fundamental disconnect in play, were the two even looking at the same phenomenon. This most of the times yields a better explanation rather than the convenient one which says that may be the market watchers were in a collective complacent stupor. We normally see such misses in the prediction of election poll results by psephologists where one ends up realizing that may be vote share gain and winning the seats are two different phenomenon and the mistake was more because of mixing the two.

So, before we go deeper into the analysis of NFP data just a word of caution for our readers. This is going to be a long and rambling post where we will also look at some of the academic literature regarding employment and the economy to make/clarify our argument. Hence in case you are in hurry please don’t say that the statutory warning was not provided. Now let’s come back to the reasons behind the NFP surprise. There can be many. Maybe the economy is weak and hence not enough jobs are getting created. New jobs are hard to come by when any economy is already working at its maximum output level. The other reason can be that the wages which are being offered for the newly created jobs are not enticing enough for the people apply and re-join the workforce.

Let’s see the above two points in the light of an academic edifice. Our resort for the day will be a book written by celebrated British economist John Maynard Keynes in 1935 which is The General Theory of Employment, Interest and Money. Readers would appreciate the confidence of Keynes that he calls his postulates a “general” theory which is applicable generally/universally and not to a limited/special case.

Keynes builds his arguments on the classical theory and delves on two fundamental postulates. Which are:

• The wage in the market is equal to the marginal product of labour. Leaving aside the arcane language what this means is that the wage should be commensurate to the portion of GDP which will be lost in case employment is reduced by one unit (read one person). Any economy which is below its maximum output can always gain by employing the marginal labour to increase the output. Readers can see this as demand side of labour (the term labour is anachronistic in the modern global knowledge economy).
• The second postulate is that the utility of the wage should be equal to the marginal disutility of being in that employment. Readers can take a deep breath to assimilate this. This essentially says that any employment occurs only when one chooses the utility of getting a wage (bank balance, fun , shopping , purpose, existence, survival) over the disutility of getting employed (daily shave, commute, time, cognitive dissonance, hard work etc).

Now Keynes wrote all this in 1935, fast forward to today in 2021. The above two arguments still are relevant. The first one says that the jobs might not get created in case the economy is already back to a normal level. We know that is not the case as it is still under reopening, the total job numbers are still below pre pandemic levels. Still some positive GDP can be created if one new person comes into the workforce. Now let’s come to point two maybe that is relevant here. It is possible that the disutility threshold has been increased and that can happen because of multiple reasons. The unemployment benefits are enticing, the virus is still at play, may be one is making money trading stocks sitting at home. All this has raised the disutility more for which the employers now need to shell out more to compensate.

On the arguments side Fed can see this number and say that the economy is still not out of woods and hence needs more support. The congressmen can say that the unemployment benefits should be retired as soon as possible. Someone else can say that the virus fear is much more pronounced than what was previously thought and hence till the entire population is inoculated, relief should go on. Markets appear to be at ease with all these arguments and prefer the Fed approach. The rate hike expectations have been sent more in the future and the Dollar has weakened post the print. Which means more risk on, something intrinsically good for EM currencies and assets.

One last observation here, the economy has changed materially from a century back. While reading his work one can find very frequent references to strikes and tool downs which is a very manufacturing focused world view. In a world where most of the jobs are getting created in knowledge sector or are getting shipped across borders, the Keynesian arguments lack some tooth if not all.