Our analysis suggests that at least 50-60% of the decline in the participation rate is due to longer-term, structural factors, such as demographics, and that while there is some potential for a cyclical rebound in the participation rate in the near term, we expect structural forces to dominate and the participation rate to continue to decline gradually. As a result, we anticipate that the participation rate will remain between 63% and 63.5% through the end of 2014, with realizations below the current level of 63.3% most likely.

Using these projections, we then derive implied unemployment rates for year-end 2014. Under our most likely scenario, the unemployment rate hits the Fed¡¯s 6.5% threshold for rate hikes before 2015, ahead of FOMC median projections. However, we believe that this will cause a communication headache rather than an earlier than anticipated tightening, as the Fed downplays the declining unemployment rate, and instead highlights continued weakness in the participation rate, employment-population ratio, and other labor market indicators. We see the first rate hike coming in 2015 H1.

Eoin Treacy's view

The Fed has made clear that it wants to see improvement in the employment situation before considering tightening. However, as the above report highlights just how employment or unemployment are measured is a non-trivial consideration when attempting to guess what the central bank will do.

The market appears to have concluded since October that the Fed is not about to tighten prematurely with Janet Yellen at the helm. At least partly as a result, the correlation between the size of the Fed’s balance sheet and the S&P 500 continues to increase. A break in the Index’s progression of higher reaction lows, currently near 1775, would be required to question medium-term scope for additional upside.