We reached out to Mohamed El-Erian to get his take on what Friday’s US employment report tells us about the prospects for Federal Reserve policy. Here are his six main takeaways:
1. The continued strengthening of the labour market, including the net creation of 215,000 jobs in July, increases the probability of the Fed initiating its interest rate hiking cycle at the next policy meeting in September. But it is not yet a done deal.
2. While supportive of a September rate hike, Friday’s numbers were not totally determinant for two notable reasons: Domestically, wage growth remains frustratingly tepid; and, internationally, conditions are far from supportive.
3. The combination of slow wage growth and international economic fragility constitute headwinds to US economic lift off — not only cyclically but also structurally. As such, in the days and weeks ahead, the Fed will keep a close eye on three things in particular: disaggregated indicators of wage formation, demand prospects in the emerging world (particularly China), and the financial stability of Europe (including prospects of a sustainable deal between Greece and its creditors).
4. Having become a major determinant of asset prices around the world, including in decoupling them from fundamentals, Fed central bankers are also seeking to strike the right balance vis-à-vis financial markets (and not just economic conditions). They do not wish to further turbo charge prices; and they are probably not too keen on adding fuel to the vigorous financial engineering in corporate America, and on distorting even more financial asset allocations. But they also don’t wish to be the cause of a disorderly rout in markets, especially when it comes to risk assets.
5. Given all these considerations, look for Fed officials to continue to manage market expectations towards the likelihood of a September rate hike. They will do so in a rather gentle and measured fashion, stressing that they intend to keep their options open until the last minute — re-iterating over and over again the notion of data dependency.
6. Finally, we should not forget the global dimension. In the line-up of major central banks around the world, the Fed is the most likely to hike, and will likely remain in this pole position. It is followed by the Bank of England, with the European Central Bank and the Bank of Japan well behind. All this illustrates once again the general global theme of central bank divergence, a phenomenon that also plays out in asset price formation. As such, “relative” trades will continue to provide interesting opportunities.