MARKETWATCH June 28- July 2
Initial market reactions to the June employment report confirms trends over the week. While safe haven effects have continued to underpin investor demand for U.S. Treasury instruments, investors have increasingly turned their focus from crisis (mainly in the eurozone) to mounting signs of weakness in the U.S. economy.
Thoughout this week, markets reacted to a series of reports raising questions about whether the U.S. economy is downshifting to a sluggish pace or even risks a double dip recession. Today's (July 2) employment situation report (sample from mid-June) showed that while forward momentum continued in the job market (private sector jobs were again added), underlying trends were weak. In a separate survey (the unemployment report consists of two surveys - the payroll and the household surveys), the unemployment rate actually declined (from 9.7% to 9.5%). However, this is misleading: the rate decline reflected a drop in the labor force (ie, the denominator of the unemployment ratio) that was larger than the drop in employment. The labor force dropped because participation declined - which typically signals weakness in an economy. (Also, labor force trends around the time of high school and college starts and stops are notoriously hard to read; seasonal adjustment factors do not sufficiently correct for the school-year "noise".)
The shift in market focus to economic fundamentals also reflects diminished worries about the eurozone. While serious concerns remain, developments in the past few days were not as dire as many investors had expected. (For example, while the sector is clearly troubled, Spanish bank participation in this week's ECB auction was lower than anticipated, so expectations about the depth of Spain's problems were adjusted. That being said, expectations are fragile and could be reversed.)
Worrying for responsible fiscal policy wonks (on behalf of the taxpayer), investors continue to return to Fannie Mae and Freddie Mac paper, even though the mortgage market continues to be troubled - to say the least - and both Fannie and Freddie pose great challenges for the government safety net. As Congress tries to wrap up financial sector reform, it appears that reform of the Fannie and Freddie situation (the government formally took them over and placed them in conservatorship when the subprime crisis exploded) will be postponed until sometime in the future. As a result, investors see that they can get higher returns on their paper than on standard Treasury instruments (because there is more risk considered involved with F&F), but, at the same time, they are gilt-edged (that is, the government continues to stand behind them and so investors calculate their risk:reward balance accordingly).
As we head into the 4th of July weekend, U.S. interest rates at both the short and long end remain very low. At the short end, Fed policy dominates. At the long end, economic weakness and safe haven effects are the key factors.