Our last blog published in early April titled “Sugar High” highlighted two aspects of the U.S. economic data we were closely monitoring:
- The pace at which we fill the 8.4 (now 8.2) million jobs gap versus structural shifts in the economy
- The interplay between commodity prices, core inflation, and inflation expectations
These two observations proved to be extremely timely. With another month of jobs and inflation data now in hand, as well as time to digest the fixed income market’s reaction to the data, here is an update on our thinking.
The pace at which we fill the 8.4 (now 8.2) million jobs gap versus structural shifts in the economy
The April jobs report highlighted that the pace at which we will fill the jobs gap is neither guaranteed nor certain. Even though real GDP is expected to fully recover to pre-COVID levels by Q2, the labor market still has a long way to go, and it remains unclear the extent to which the labor market will be permanently changed. The U.S. economy has recovered 64% of lost payrolls since the all-time lows recorded twelve months ago. Despite the fact that this recovery is about three times faster than the period after the global financial crisis (GFC), we all can agree that the 266k jobs created in April was an enormous disappointment versus expectations and a whisper number of 1mm+. This begs two important questions: 1) Are we still on the path of “substantial progress” that will enable the Federal Reserve (Fed) to begin to discuss tapering this fall; and 2) was the poor print due to a structural shift in the economy or was it merely a transitory supply/demand mismatch, which should resolve itself as vaccination rates rise and parents return to work as childcare becomes more certain.
If we take a step back, while 1mm non-farm payroll (NFP) prints would be incredibly well received, the Fed might not actually need such robust job growth. The current 3 month average pace of job creation remains strong at 524k, and should we continue on this trajectory, we will have recovered more than 70% of jobs lost by the time the Fed meets at the Jackson Hole Symposium in August. This is probably very close to what the Fed would deem substantial progress, but it is not a lay-up. For context, the jobs market had recovered about 75% of its lost payrolls post GFC by June 2013, though at a much slower pace, when tapering was first mentioned. As a result, we believe a 70% recovery at a faster pace this time around will put us back in the tapering ballpark, though ultimately the decision will rely on a broader mosaic of labor market data points. Indeed, the next few jobs reports will be critically important to understanding whether labor supply and demand are constrained simply because of a timing mismatch as the economy re-opens, or if it is a problem created by structural changes in the wake of the pandemic. The difference between these two outcomes may determine whether we are able to move the needle on substantial progress and thus remain on track to taper asset purchases by the start of 2022.
The interplay between commodity prices, core inflation, and inflation expectations
We got a huge inflation surprise to the upside versus consensus, making the miss on payrolls look like a blip on the radar. Core CPI came in at 0.9% month-over-month (MoM), which resulted in a 3% year-over-year (YoY) change, the fastest annual rate since 1995! Half of the monthly increase came from categories related to auto travel, stemming from the surge in used auto prices and supply chain bottlenecks related to chip production shortages impacting new car prices. Furthermore, if we account for surges in hotels and airfare, as well as the continued rise in furniture prices, we find that a set of relatively small categories (~20% of the basket) contributed almost 80% of the monthly core increase. Meanwhile, rents rose only modestly and medical care was flat. While it was, undoubtedly, a stunning print, the underlying mix of inflation fits squarely within the Fed’s definition of transitory. But does the market think the same? At the moment, the answer appears to be yes.
In our last blog post, we highlighted the 5y5y forward inflation swap measure and the inversion of the spot inflation curve. Since then, the inversion in the breakeven curve has persisted as commodity prices have turned parabolic. 5y5y forward inflation has crept up to 2.50% - about 15 bps higher over the last month. Despite the notable rise in the 5y5y inflation market measure, it remains within the realm of recent experience and still below pre-2014 trends. Meanwhile, 10yr nominal Treasury yields have been range bound throughout this volatility in the growth and inflation data. Our interpretation of the recent price action is that the rates market is struggling to glean insights about the U.S. economy beyond the very near term and is thus judging that this cyclical surge in growth and inflation will eventually revert to the mean. The market’s reaction to the CPI report was a perfect example of this: 5y5y inflation expectations actually moved lower after the release and the nominal treasury curve flattened. So, why does this matter?
A meaningful shift higher in developed market yields and/or a significant steepening of the nominal curve can only be achieved if the market is able to look beyond the next 3-6 months and seriously consider the possibility of higher structural inflation and/or growth. Neither of these seem possible until we get through the noise of the initial re-opening data. This is exemplified by the market’s inability to allow long-dated forward rates (e.g. 10y1m OIS) to trade above the Fed’s long run dot, which is currently at 2.5%.
We also referenced the Fed’s Common Inflation Expectations index (CIE). While this measure is intended to gauge long-term expectations that strips out near term volatility, we hypothesized that the 60% increase in gasoline prices over the last year could sneak its way into certain subcomponents of the index, particularly consumer expectations. Survey measures have indeed risen as we suspected, but we think it is critical not to discount this trend. It is entirely possible that buoyant commodity markets, accommodative fiscal and monetary policy, and a general saturation of the inflation narrative amongst the public will create a positive feedback loop that helps re-anchor long-term inflation expectations higher. The key risk, therefore, is that this temporary surge in prices and upward drift in expectations results in a permanent shift in consumer behavior, leading to a persistent rise in inflation that makes the Fed uncomfortable. At the moment, however, we think the Fed will view the increase in the CIE as a desired outcome that is consistent with their goals and, all else equal, validate the need to remove extraordinarily easy policy in the relatively near future.
As we move forward, we are watching closely for signs that labor supply constraints are easing, such as a pick-up in payrolls growth and labor force participation, as well indications that the inflation uptick is indeed transitory, such as a retracement lower in durable goods prices as supply chains adapt and demand shifts back towards services. While this is the Fed’s base case, the market still needs to see the air clear before it can look out towards the horizon.