How Falling Unemployment Could Hurt Investors

As the job picture improves, the end of some key stimulus measures draws closer.

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If the U.S. economy needs anything, it's more jobs. But investors ought to be careful what they wish for.

A sustained period of robust hiring—such as the 236,000 news jobs added in February—would fill in the missing piece that's left the economic recovery incomplete nearly four years after the 2007-2009 recession ended. But if hiring were strong enough to significantly push down the unemployment rate, it would trigger another momentous development—the end of the Federal Reserve's aggressive loose-money policies.

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The Fed has said it will keep its controversial stimulus measures in place until the unemployment rate falls to around 6.5 percent, as long as inflation remains under control. At 7.7 percent, unemployment is still a long way from the Fed's target. But the Fed could begin a gradual pullback, or even signal a future pullback, before unemployment falls all the way to 6.5 percent. That's why figuring out when the Fed will begin to reverse course has become the biggest guessing game on Wall Street.

The Fed's generous policies have been a major factor contributing to the four-year bull market in stocks, so any sign of a policy change could have the opposite effect. "If we see evidence that the economy can stand on its own two feet—meaning the Fed could take its foot off the accelerator—I would expect some pullback in stocks," Russ Koesterich, chief investment strategist for money-management firm BlackRock, wrote in a recent blog entry.

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The latest jobs report was much better than economists had expected, with employers apparently unfazed by budget battles in Washington, which some analysts thought would tank the whole economy. If that pace of hiring were to hold up through all of 2013, it might prompt the Fed to end its loose-money policies sooner than expected.

It seems more likely, however, that the vigorous pace of hiring will fade. Bank of America Merrill Lynch predicts that job creation in March will be a typical 175,000 or so. But in April and May it could plunge to less than 100,000 and even turn negative, as the government spending cuts that went into effect March 1 begin to impact the real economy.

If that happens, it would probably push the unemployment rate back up and renew concerns about the fundamental strength of the economy. Fed Chairman Ben Bernanke probably wouldn't be surprised. He has consistently said the economy still needs help, while reiterating the Fed's commitment to do whatever it can to drive down the unemployment rate.

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Still, the economy has been more resilient than expected lately, and even inside the Fed, the debate over when to end quantitative easing has intensified. The Fed's policies have become so dominant that even rumors of change have pushed stocks down.

Sooner or later, of course, the Fed will have to start raising interest rates and unwinding other extraordinary policies of the last four years. No matter how strong the economy, it will be a tense moment when the Fed first signals a tighter policy and investors discover whether stocks are able to remain buoyant, with less of an updraft from the central bank.

If the economy really is stronger by the time that happens, investors may shrug off the change the way they've shrugged off dysfunctional politics in Washington. "I don't think markets will panic when the Fed tightens," says Mike Thompson, managing director of global markets intelligence for S&P Capital IQ. "It's not going to happen overnight, and the Fed will probably say this is going to be a slow and adjustable process. It might even boost confidence if the Fed really does believe the economy is improving enough to change its policy."

Whenever it happens, the unemployment rate will be the number that best charts the Fed's timing. No matter which direction it goes, it's probably smart to keep your broker's number on speed dial.

Rick Newman's latest book is Rebounders: How Winners Pivot From Setback to Success. Follow him on Twitter: @rickjnewman.