Labor costs and oil prices will drive this week's market

Readers of this blog who think of themselves as long-term investors may choose not to trade on such short-term fluctuations. However, institutional investors -- including hedge funds which control a big chunk of daily trading volume -- move markets based on such trades.

So let's think about what might happen this Tuesday assuming that the market puts its primary focus on the Fed. According to Bloomberg, US interest rate futures gave the Fed a scant 21% chance of raising interest rates - a decision it will announce this Tuesday at 2:30pm. This is down from a 43% chance prior to last week's-worse-than-expected employment report. However, it's up from the 15% chance envisioned last Friday -- suggesting that rising oil prices may be increasing investors' inflation concerns.

Why the declining odds of a 25 basis point interest rate rise? As my earlier post suggests, the Fed will set interest rates based on labor cost inflation, not consumer price inflation -- which, at 4.3%, is running well above the Fed's 1% to 2% target. The market reasons that with unemployment rising and job creation running at a lower pace than expected, employers will not need to pay higher wages to their workers.

Thus, the market believes that the Fed will not raise rates because the risks of causing a recession through a rate rise exceed the danger of above-target inflation. But the key here is the specific number that the market will be tracking. And that number is unit labor costs, which economists surveyed by Reuters expects will rise at a 3.5% annual rate when the Labor Department reports it on Tuesday at 8:30am, prior to the Fed announcement. (I am assuming that the Fed has this report when it debates its rate decision on Tuesday). According to TradingMarkets.com, the preliminary reading is expected to reveal a far lower 1.1% unit labor cost increase.

Interest rate futures as of August 7th suggest that there's a 79% chance that the Fed will not raise interest rates. Therefore, traders are likely betting on the following:

• A decline in the value of the dollar because investors will conclude that other countries are more serious than the US about fighting inflation -- and they will buy Yen to profit from the trend;
• A rise in the price of gold which tends to move in the opposite direction of the dollar;
• An increase in the value of shorter term government bonds because these bonds wil become more valuable as investors realize that their yields are likely the highest that investors will get in what could be a multi-year period before the Fed starts raising rates again; and
• An increase in stock prices which will rise because the value to investors of stocks' future earnings will increase since the discount rate used to calculate earnings' worth in today's dollars will be less than they had expected.

Given the high odds that the market is placing on the Fed not raising rates, these bets will probably not yield much profit because the market is already expecting the Fed to stand pat. But if unit labor costs rise more than 3.5%, traders who bet on an increase in the dollar's value, a drop in gold, a decline in bond values, and a drop in the stock market will make much bigger profits.

With labor costs and oil prices in flux, this week's market promises to be a turning point for the future.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm, and a Professor of Management at Babson College.