Another reason to be wary of bonds – US workers’ wages are rising

The US economy got some good news on Friday.

People are getting jobs. They're getting pay rises. They're probably feeling more confident and ready to spend.

So naturally, the market took it badly

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America's jobs picture is looking a lot brighter

That was much bigger than the 225,000 that Wall Street was expecting. And the rest of the report was strong too.

Firstly, March and April's payroll gains were revised higher. The share of the US population in work is now at its highest since the recession.

Secondly, unemployment edged up from 5.4% to 5.5%. Wait a minute why's that a good thing? It's a good thing because the rise was driven by nearly 400,000 people entering the labour force. In other words, the number of people actively looking for work is rising.

That's a good sign because it means that the number of discouraged workers' people whose hopes of ever getting a job have deteriorated to the point where they've given up is on the decline. That suggests broader optimism and a healthier jobs market.

Thirdly, and most importantly, wage inflation is picking up. Average hourly earnings grew by 2.3% year on year. It was the biggest such jump in nearly two years. And while it's not huge, as Capital Economics points out, if you look at the quarter-on-quarter rise, then pay is rising at an annual rate of 3.3%. In short, pay growth is accelerating.

This all suggests that the relatively weak GDP growth seen in the first quarter was down to the winter, rather than anything more lasting.

Good news for the economy then. So predictably enough, the dollar shot up, but stocks weren't so keen.

Why the financial world dreads good news for the real' economy

With its typically woeful timing, the International Monetary Fund (IMF) argued last week that the Fed should delay raising rates until 2016. But this sort of jobs report "definitely brings [higher] interest rates into 2015", as one analyst told the FT perhaps in September.

Clearly, though, the tricky problem is that the financial markets have grown used to pricing every market but particularly the bond market as if QE and zero-interest-rate-policy will go on forever.

If that's wrong and it is a big assumption to make then panic could ensue. We got a taste of that in the German bund market recently, and it could stretch much further if there's a broader rush for the exits.

The FT quotes Hans Stotter of NN Investment Partners as saying that bond market volatility reflects investors playing the "closest-to-the-door game". Everyone is up on the floor dancing as per Citi's Chuck Prince but they're all ready to run for the door the instant it looks like things are going pear-shaped.

The trouble, says Stotter, is that the door turns out to be a window. When everyone tries to get out, everyone gets stuck.

It's just another reason to be very wary of bond market exposure. As Mohamed El-Erian writes in the FT, "investors should brace themselves for additional bouts of bond market volatility as part of a threat of broader financial instability".

Is there any possibility of a happy ending to all this? El-Erian argues that "the only durable antidote" is "a stronger broad based recovery in fundamentals that better anchors valuations and allows central banks to gradually normalise policy".

So a half-decent recovery is needed to make investors confident that the economy can stand on its own two feet. That's quite a big call too. Monetary policy has distorted so many elements of the economy that it's hard to say which of these industries are ultimately dependent on the cheap money continuing to flow (the shale oil bonanza is one good example of a business sector that's largely survived and thrived on cheap money and irrational exuberance).

But even if we do get a healthy recovery somehow, then investors need to understand that a recovering economy would be bad news for bonds generally fixed income investments don't fare well in rising inflation, rising interest rate environments, because the fixed income they pay becomes steadily less valuable.

In a growing economy with a rising but not catastrophic rate of inflation, equities are a better bet. But even then, you'd be better off avoiding the most over-priced markets, which include the US just now.

You can read more about why we're wary of US stocks in the latest issue of MoneyWeek magazine, out just now. (If you're not already a subscriber, get your first four issues free here.) But there are plenty of better bets out there. And I'd hang on to a bit of gold as insurance of course, just in case the end of loose monetary policy all goes horribly wrong.

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