The January 2018 jobs report practically confirmed what we all suspected - the U.S. economy appears to be firing on all cylinders. In January the economy added 200,000 jobs. The figure surpassed the 180,000 economists were expecting:

Non-farm payrolls rose by 200,000 in January, topping economists’ expectations for 180,000, according to a Thomson Reuters poll. That compared with a revised 160,000 in December. The report showed strong employment growth in construction, food services and healthcare ... 

The unemployment rate held steady at 4.1 per cent for the fourth consecutive month, in line with expectations. “It definitely makes it a bit more likely that the Fed will has to do more than the three hikes that they’re currently planning for this year,” said Luke Bartholomew, strategist at Aberdeen Standard Investments. “US bond markets aren’t going to like it though. Treasuries have been suffering a sharp sell-off and such strong numbers are going to pour fuel on the fire.””

The jobs number was up from the 160,000 jobs added in December, and off the 259,000 jobs added in the year earlier period. Construction and leisure and hospitality were particularly strong, having grown jobs by 36,000 and 35,000, respectively. If interest rates continue to rise due to fears of inflation or simply due to the Fed's unwinding of its $4 trillion bond portfolio, it could choke off construction.

Unemployment Rate Remained At 4.1 Percent

The unemployment rate of 4.1% was the same as that of the previous month and down from 4.8% versus the year earlier period. With an unemployment rate of 5.0% or less, economists consider the economy to be at full employment. That is usually considered a good thing. If there is no slack in the labor market, then potential employees should be able to demand higher wages in order to [i] enter the labor market or [ii] keep from switching jobs. If that theory holds, then we should also see strong wage growth.

The rub is that higher wages could drive higher interest rates, and potentially hurt the stock market. Over the past decade rising stock prices has been considered good for the economy. That said, average hourly wages of $26.74 were up 0.3% versus December 2017, and up 2.9% Y/Y. The Y/Y gain was the fastest rate of growth since 2009 and topped forecasts of 2.7%. It also gave credence to the notion that since the unemployment rate signals we are beyond full employment, workers could potentially demand higher wages by playing employers against each other.

Wage growth could quicken once President Trump's tax cuts fully kick in. Companies could share their windfall in the form of higher bonuses to employees. They could also buy back more shares and spike stock options for executives. Financial markets reacted immediately to higher wage growth. Ten-year treasuries exceeded 2.8% for the first time in over eight years. The Dow Jones (DIA) sold off immediately, and is off over 3% since the jobs report was announced. Ten year treasuries are the key to mortgage rates. Also, several companies took out-sized risks - share repurchases, acquisitions - when rates were at record lows. Companies' cash flows could be hampered when cheap debt has to be refinanced at much higher rates. This could be a cause for concern for financial markets going forward.

Inflationary Expectations Could Embolden The Fed To Hike Rates

The big question facing financial markets now is, "What will the Fed do?" Fed Chairwoman Janet Yellen previously intimated her desire to unwind the effects of quantitative easing ("QE"). That process appears to be underway, albeit very slowly. New Fed Chairman Jerome Powell has intimated he will go ahead with gradual rate hikes despite volatility in the financial markets:

Federal Reserve Chairman Jerome Powell suggested that the U.S. central bank would push ahead with gradual interest-rate increases even as it remains on the lookout for threats to the financial system in the wake of the recent stock market rout.

“We are in the process of gradually normalizing both interest rate policy and our balance sheet,” he said Tuesday in the text of his ceremonial swearing-in speech in Washington, adding, “We will remain alert to any developing risks to financial stability.”

There are fears that the Fed could get behind the curve if it waits too long to raise rates. I am of the belief that the Fed should normalize interest rates in order to see what the true state of the U.S. economy truly is. If the economy falters then we know prior stimulus might have been ineffective, and we need to try new methods. Secondly, this presents an opportunity for Powell to define the Fed's mandate under his regime. Should it fight inflation like former Fed Chairman Paul Volcker vowed to do? Should it stabilize financial markets at all costs? This appeared to be the mandate of global central bankers over the past decade.

Three or four rate hikes might not have an impact on long-term rates. Ultimately, investors have to decide if inflation warrants a sell off in long bonds. However, multiple rate hikes could finally send a signal to the equity markets that the Fed will no longer buttress stocks and encourage risk taking. Such a signal could send financial markets into a deeper tailspin. In my opinion, investors should avoid financial markets until the Fed hikes rates and the dust settles.