Jobs Data Move 10-Year Trading Range

Today's report has put 4.25% on the horizon, and the yield move is hurting the homebuilders.
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The economy was looking good in most investors' eyes even before today's payroll report, and no matter how the report looked, these views were unlikely to change. This was unusual because the jobs report is often seen as extraordinarily important in providing guidance on the economic outlook.

However, strong consumer spending and a surge in manufacturing activity has made it clear that the economy is on sound footing and today's jobs report reinforces this view.

Importantly, today's report solidifies the view that the

Federal Reserve

will likely raise the federal funds rate to 4.25% by at least the first quarter of next year, if not year-end. As I have said recently, if this view becomes even more entrenched, the 10-year T-note, which has seen its yield rise almost 50 basis points over the past month, might see its yield range reset to 4.25% to 4.75% from the current 4% to 4.5% range that has prevailed over the past two years.

Why? Because investors are loath to invest in Treasuries when they yield less than the fed funds rate, primarily because the fed funds rate represents the cost of money to those who borrow money in the repo market to finance their inventories of Treasuries. This is of particular importance to the primary dealers, which finance fixed-income inventories via the repo market.

So with the fed funds rate looking increasingly as if it's headed toward 4.25%, Treasuries are threatened in ways they haven't been threatened in this cycle, as it is rare that Treasuries trade at yields below that of fed funds. The only occasions that they do are when the Fed is expected to lower the fed funds rate, hence alleviating the so-called negative carry situation, which occurs when Treasuries yield less then the fed funds rate.

There have been only five occasions in 16 years in which Treasury yields dipped below the fed funds rate. On each occasion, the Federal Reserve lowered interest rates within six months, with most rate cuts occurring much sooner than that. Such negative carry was tolerated only for a short while, because it was expected to be alleviated by Fed rate cuts.

Proprietors Still Faring Well

The payroll gain of 207,000 was 27,000 more than expected, and revisions to past months added 42,000 jobs to the tally. The gain put the average monthly gain for 2005 at 191,000, compared with 171,000 in 2004. The acceleration is validated by a variety of indicators, particularly the recent jobless claims data and the monthly data on personal income.

Speaking of personal income, which is now up a solid 6.8% vs. a year ago, July's payroll gain will keep it on a solid upward trajectory. Reinforcing this point were the data on household employment, which is the tally of employment as measured by a survey of households rather than establishments. (For those unaware, the establishment survey produces the payroll data.)

In July, household employment increased 438,000 and has increased an average of 386,000 per month over the past five months. The gain likely reflects continued strength in self-employment, which is counted in the household survey but not in the payroll survey.

The capturing of self-employment is important because there has been a greater proclivity toward such jobs in recent years, Whether it's an eBay seller, a computer consultant, or a Web designer, the economy is composed of more than just big companies these days, ostensibly helped by government initiatives toward the small business sector. This has helped to propel proprietors' income, which accounts for about 10% of all personal income, to a gain of 8.4% vs. a year ago.

So, the strength seen today in household employment suggests that personal income growth is continuing to get a boost from the growth in proprietors' income. With personal income growing strongly, the rise in energy costs continues to be offset and therefore remains the main explanation as to how the economy has been able to fare well in the face of the energy-price rise.

In the context of the success of small businesses, investors would be wise to shop for companies that are catering to the self-employed and to small businesses, as well as for companies benefiting from outsourcing, which is in the midst of a secular upturn. Large companies are continuing to streamline, and this is bolstering the fortunes of others.

Digging Deeper

The service sector fared well in general, accounting for 203,000 of the 207,000 jobs added during the month.

Leisure and hospitality jobs grew by a strong 33,000 in July, underscoring the strength in travel, tourism, recreation, and eating and drinking establishments. Such might also provide an explanation as to why July chain store sales were mediocre. With people traveling more and enjoying themselves outdoors, they simply didn't shop as much. As an aside, the extraordinarily high level of car sales seen in July (third-best ever) reduced the consumers' buying power during the month.

Health care saw a gain of 29,000 workers, led by gains in ambulatory health care services (+14,000), offices of physicians (+6,000), and outpatient care centers (+3,000). Powerful demographics continue to support this sector.

Professional and business services added 33,000 jobs during the month, led by gains in a variety of industries including legal, accounting, architectural, and computer services. Management and technical consulting services added 6,000 jobs to 814,000.

Average hourly earnings rose by 0.4% during the month, the largest monthly increase since July 2004. Still, the year-over-year gain is just 2.7%, so it is too soon to say whether a pickup in hourly earnings is under way. Keep in mind that hourly earnings represent wages received by nonsupervisory workers and exclude many other forms of income that households receive. Nonetheless, hourly wages have been growing slowly for quite some time now.

In sum, today's news will convince many that the federal funds rate is headed higher. If it does, the 10-year may reset its trading range and such a prospect is already having a deleterious effect on homebuilders' shares.

Toll Brothers

(TOL) - Get Report

was recently down $4.07, or 7.42%, to $50.81;

Pulte Homes

(PHM) - Get Report

was off $4.47, or 4.82%, to $88.21; and

Centex

(CTX)

was off $3.91, or 5.33%, to $69.47.

More of the same and a broadening of such impact is likely if the 10-year probes high enough to convince investors that a new yield range has indeed been set.

Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of

The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback;

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