Introduction

Softening economic data together with extreme volatility in the financial markets had been raising expectations for an easing in Federal Reserve rate hikes and also balance-sheet reduction. But that was before an unusually strong December employment report that, despite soothing comments from Jerome Powell and despite Friday's giant surge in stocks, has arguably turned back the outlook to where it was in September and October, that is a fast growing labor market consistent with increasing risks of overheating and inflation and with that, the continuing need for further rate hikes and balance-sheet unwinding. The dovish spin that ended the year and popped back on Friday is at risk of being replaced by the old hawkish one. It was a week of both good and bad news so let's begin with the good first.

The economy

Nonfarm payrolls rose 312,000 in December for the strongest showing since February last year and among the very strongest of the whole expansion. Manufacturing payrolls rose a higher-than-expected 32,000 to extend their long run of strong showings. Construction posted an outsized 38,000 increase with mining, a much smaller industry, rising an in-trend 4,000. Retail trade rose a solid 24,000, trade & transportation a solid 34,000 after a 68,000 November surge, and professional & business services gained a very strong 43,000 with temporary help, which is in demand, up 10,000.

A head fake in the report is a 2 tenths rise in the unemployment rate to 3.9 percent which, instead of reflecting moderation in the labor market, reflects a very welcome rise in those actively looking for work, to 6.294 million from 6.018 million. This suggests that discouraged workers are growing less discouraged and, seeing more and more help-wanted signs, are back pounding the pavement. This part of the survey measures total employment, that is the self-employed not just those on payrolls. Here the number of employed rose 142,000 in the month which together with the 276,000 rise in actively unemployed (which are counted as part of the workforce) made for a strong 419,000 jump to 163.2 million for the total labor force. The participation rate, also dervied from this side of the report, is another strong positive, rising 2 tenths to 63.1 percent which is also better than expected and the highest reading since September 2017.

And posting the very strongest reading of the expansion for the second time in three months are average hourly earnings, at a year-on-year 3.2 percent. The monthly rate of increase was an outsized 0.4 percent for the hottest reading since December 2017 and also among the very strongest of the expansion. Average hourly earnings, which are one of the key measures of wage inflation, are trending clearly higher and are hinting – at last – that rising demand for labor is actually being accompanied by rising pay for labor. Yet Jerome Powell, in comments at an economics panel following release of the report, did not underline the climb underway in hourly earnings, instead describing general inflation pressures as "muted" and an important factor that will allow the FOMC to be "patient" in any further rate increases. Whether 3.2 percent and rising is muted is an open question but in any case, we'll close the employment situation with Powell's overall assessment of the report: "very strong".

What makes December's employment report so surprising is, not only its actual strength, but its contrast with other economic data that have clearly been slowing. Advance indications from reports like those from the ISM and Markit Economics have suddenly fallen through the floor. ISM's index, down more than 5 points in December to 54.1, was well below bottom-end forecasts for the lowest reading in two years. The weakness in ISM was centered where it is least welcome, in new orders which fell more than 10 points and, at 51.1, is suddenly very close to breakeven 50. Markit's manufacturing PMI fell 1-1/2 points to 53.8 which is a 15-month low with order growth and also business optimism down as well.

But these results are not confirmed by the employment report where payroll growth in manufacturing proved outstanding with data for factory hours turning higher. Manufacturing hours are direct inputs into the Federal Reserve's industrial production report which, in contrast to the factory data published by the Commerce Department and Bureau of Economic Analysis (BEA), will continue to be released despite the government shutdown (the Federal Reserve is not affected). Lack of data will make it harder for economists to forecast the numbers that continue to be released, giving heightened importance to private surveys like the ISM. The graph tracks the green line of ISM manufacturing production against the blue columns of manufacturing production as measured by the Fed. Both measure volumes and though ISM's reading rarely breaks into monthly contraction, defined by the BEA as under 51.5, the trends for each are at least similar -- showing steady growth for the long-term picture. Still, for forecasters the factory signals from the ISM and the employment report are clearly in conflict.

And the nosedive in the ISM was fully telegraphed by regional manufacturing reports. The Dallas Fed opened the week posting its first negative reading, at minus 5.1, for the first time since September 2016. And compared to November's plus 17.6 showing, the 22.7-point swing is the largest in 14-1/2 years of records and offers a memorable yardstick on the impact that lower oil prices have on this sample. The recent $20 drop in oil is in fact key for many manufacturers and critically so for those producing energy equipment. Perhaps the effect of oil as well as continuing uncertainties over tariffs are not being reflected in the sector's employment numbers? This is a reminder that employment can be a lagging indicator tied to the long lead times needed to attract and hire new workers. In the meantime, however, orders in the sector may be coming to a sudden standstill.

Not coming to a standstill, at least yet, is the Fed's balance-sheet unwinding. December marked the end of its initial 15-month program, trimming Treasury holdings to $2.223 trillion for a $243 billion decline from October last year. Holdings of mortgage-backed securities (MBS) are at $1.637 trillion for a $131 billion decline. These are substantial amounts and, for many in the financial markets, perhaps too substantial. Yet not for Jerome Powell who continues to praise the pace and orderliness of the program, calling it once again an "auto-pilot" unwinding. But auto-pilot may not be the most accurate of terms since the total unwinding of Treasuries and MBS fell $76 billion short of the $450 billion goal. That's 17 percent short! At last month's FOMC the Fed set the targets for the second part of the program, a $50 billion monthly reduction split $30 billion for Treasuries and $20 billion for MBS until further notice. But should we instead discount these levels by 17 percent or so? Will the reduction actually amount to more like $25 billion per month for Treasuries and $16 or so billion for MBS? Still, these are sizable.

A more fundamental question, raised during the week by Dallas Fed President Robert Kaplan, is whether the whole program should be cut back or paused altogether. At $4.058 trillion, the Fed's total balance sheet including all securities not just Treasuries and MBS is $402 billion smaller than it was in October 2016. That's $402 billion not in the capital markets any more and, in turn, not available to financial markets as a whole. This is being understandably blamed for much of the damage to the stock market. On Friday, Jerome Powell said he wouldn't hesitate trimming the monthly reductions if needed in comments that helped what was a very strong session for stocks. But as it stands right now, the Fed over the next year has slated another $600 billion to be cut from its balance sheet in $50 billion monthly increments as tracked in the gray part of the accompanying graph. If the markets complained about $400 billion, how about $600 billion!

Markets: One day one thing, the next day the next

Events in the markets are increasingly compressed, that is sudden reaction and over-reaction to events big and small. The jump in the December employment report clearly does not reduce the odds that the FOMC will follow through with its plans for two more rate hikes this year, if anything it pulls chances for the first hike closer. And Powell's comments Friday, though on the dovish and pleasing side, do not mark a reset in the policy outlook and hardly justify the Dow's tremendous Friday rally of 3.3 percent. During the Dow's tumble of 2.8 percent on Thursday, which was a reaction in part to the sudden drop in the ISM, money poured into the Treasury market. The 2-year yield, down 9 basis points on Thursday to 2.39 percent, hit the Federal Reserve's 2.385 percent target for the overnight federal funds rate. Demand was also strong for long-term Treasuries with the 10-year yield, at 2.56 percent, also down 9 basis points. This is really a flat yield curve with the overnight rate within striking distance of the 10-year rate. And underscoring the volatility of the markets, these movements were fully reversed on Friday. If and when the Fed does raise rates again, a 25-basis-point move could very well lift the overnight rate above the 10-year. In doing so, the Fed would confirm for all that it has no fear of an inverted yield curve.

The bottom line

Friday's market action and big rally for stocks could be wishful thinking. An extended run of the kind of numbers in December's employment report, even just a one-month repeat in the January report, could cement the determination of the Fed to carry out its rate-hike and balance-sheet unwinding plans without hesitation or interruption. Yet whether job growth can keep up December's pace is a very fair question, given the sudden deterioration in many factory indicators and also the housing market which ended a bad year in an increasing slump. But for now, given the strength of the labor market, it may be prudent to quiet down the dovish talk about a reluctant Federal Reserve.

Week of January 7 to January 11

Unless there's a big surprise for what is nearly always a very tame consumer price report, the coming week's run of economic data does not look to have any of the punch of the employment report of the prior week. The government shutdown, which has closed the Commerce Department and Bureau of Economic Analysis, will further dampen the activity, scratching factory orders on Monday and the trade balance on Tuesday. But the Labor Department remains open which secures Tuesday's release of JOLTS data and Thursday's jobless claims report. JOLTS will be worth watching as the rise in those looking for work, one of the highlights of the December employment report, will help take the edge off any further surge in job openings. FOMC minutes, on Wednesday afternoon, will be the midweek highlight and will offer details on December's hawkish results that included a rate hike and promises for more to come. Friday's CPI isn't expected to show much pressure at all, at minus 0.1 percent at the headline level and plus 0.2 percent for the core. Yet if the December employment can shock to the upside, perhaps the CPI can as well. But a shock either up or down for the CPI, however unlikely, could unsettle the rate outlook once again and with it the markets as well.

Monday

Factory Orders for November

Consensus Forecast, Month-to-Month Change: 0.4%

Consensus Range: -0.5% to 2.6%

Advance data for the durables side of the November factory orders report rose 0.8 percent reflecting a swing higher for both civilian and defense aircraft. Ex-transportation orders, however, fell 0.3 percent with core capital goods orders down 0.6 percent. Forecasters see factory orders in November, which will include initial data on non-durable goods, rising 0.4 percent. Note this report will be delayed because of the government shutdown.

ISM Non-Manufacturing Index for December

Consensus Forecast: 58.4

Consensus Range: 54.6 to 60.3

A robust but easing rate of growth is the call for ISM's non-manufacturing index for December, at a consensus 58.4 vs 60.7 in November. This indicator has beaten Econoday's consensus for the last four reports and beat the high estimate in November. New orders including export orders were central strengths in the last report.

Tuesday

Small Business Optimism Index for December

Consensus Forecast: 104.0

Consensus Range: 100.7 to 105.0

The small business optimism index is expected to ease slightly to 104.0 in December vs November's 104.8. November saw dips in economic optimism, sales expectations, and current job openings.

International Trade Balance for November

Consensus Forecast: -$53.9 billion

Consensus Range: -$54.8 to -$51.8 billion

Forecasters see the November international trade balance at a consensus deficit of $53.9 billion. This would compare with a $55.5 billion deficit in October and a monthly average deficit of $52.8 billion in the third quarter. Note this report will be delayed because of the government shutdown.

Consumer Credit for November

Consensus Forecast: $19.0 billion

Consensus Range: $15.0 to $29.0 billion

Substantial growth of $19.0 billion is expected for consumer credit in November following October's sharp increase of $25.4 billion that showed a jump in revolving debt.

Wednesday

FOMC Minutes

Released for the December 18 & 19 meeting

The December FOMC produced its own 25-basis-point rate hike and though members cut the number of expected 2019 rate hikes from three to two, the markets saw the meeting as hawkish. The employment and inflation debates will be closely watched as will any details highlighting the Fed's flexibility on balance-sheet unwinding.

Thursday

Initial Jobless Claims for January 5 week

Consensus Forecast: 222,000

Consensus Range: 215,000 to 225,000

Initial jobless claims have been moving up to the higher levels seen in November. But forecasters see initial claims for the January 5 week coming back down to 222,000 vs 231,000 in the December 29 week.

Wholesale Inventories for November

Consensus Forecast, Month-to-Month Change: 0.4%

Consensus Range: 0.2% to 0.6%

Wholesale inventories are expected to rise 0.4 percent in November. Growth in wholesale inventories is tracking at about the same pace as growth in wholesale sales. Note this report is likely to be delayed due to the government shutdown.

Friday

Consumer Price Index for December

Consensus Forecast, Month-to-Month Change: -0.1%

Consensus Range: -0.2% to 0.2%

Consumer Price Index

Consensus Forecast, Year-on-Year Change: 1.9%

Consensus Range: 1.8% to 2.2%

CPI Core, Less Food & Energy

Consensus Forecast, Month-to-Month Change: 0.2%

Consensus Range: -0.2% to 0.2%

CPI Core, Less Food & Energy

Consensus Forecast, Year-on-Year Change: 2.2%

Consensus Range: 2.1% to 2.3%

Easing pressure tied to lower energy costs is the call for December's consumer price index, at a consensus contraction of 0.2 percent following no change in November when oil prices first fell sharply. The consensus for the ex-food ex-energy core rate is a 0.2 percent gain vs November's 0.2 percent increase that saw steady pressure for housing costs and a bounce higher in medical costs. Year-on-year rates for December are seen at 1.9 percent overall and 2.2 percent for the core vs November's 2.2 percent for each.