May's Jobs Report Is Strong -- Why Aren't Stocks Responding?

The latest U.S. employment situation report is out, showing the economy adding 280,000 jobs in May -- well above the consensus forecast of 220,000. In the face of encouraging numbers from the single most important set of economic data, why are stocks slightly in the red on Friday morning, with the Dow Jones Industrial Average (^DJI -0.30%) and the broader S&P 500 (^GSPC -0.25%) down 0.12% and 0.06%, respectively, at 11:15 a.m. EDT?

Before I address that question, let's look at some of the key numbers in today's report:

Source: Bloomberg, Bureau of Labor Statistics.

While the unemployment rate did tick up by a tenth of a percentage point to 5.5%, this isn't problematic; as the Bureau of Labor Statistics correctly described it, the unemployment rate is "essentially unchanged."

One contributing factor to the increase: The participation rate (the percentage of the civilian population that is either employed or actively looking for work) ticked up to 62.9%, the top end of a two-tenths of a percentage point range within which it has fluctuated since April 2014. Although the participation rate remains near a historical low, any increase is welcome, as it suggests people are more confident that they will find employment.

The icing on the cake: Revisions for March and April delivered a net employment gain of 32,000 over the payroll increases that had previously been reported.

In the context of such a strong report, why is there no positive reaction from the stock market? The answer: interest rates. The unexpected strength of the employment data pulls forward the market's forecast for an initial Federal Reserve interest rate increase. Given that the Fed's zero interest rate policy, which is now in its seventh year, is helping to prop up the stock market's valuation, the prospect of a rate hike is no source of comfort for traders. (However, long-term investors, who are prepared to invest through multiple interest rate cycles, are less concerned)

But how soon are we talking about? Does today's better than expected report mean the Fed could lift rates at its policy meeting later this month? I think we can exclude that possibility right off the bat, and I would write the very same thing if the payroll increase figure had been 350,000. Today's data does suggest the economy continues to improve and that the weakness of the first quarter was linked to one-off factors (weather, a West Coast port strike). However, monthly data are volatile and the Fed will want to see confirmation of this trend before taking such a key policy step.

On May 22, Fed Chairwoman Janet Yellen said that "if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy." Today's employment data appear to vindicate her guarded optimism and suggest a first rate rise is in the cards for 2015. That would be a healthy development that long-term investors ought to welcome.