When we published the first 2 parts of our “Sugar High” series back in April and May, it appeared that there was a meaningful tug-of-war debate over whether the re-pricing higher in Treasury yields was a reflection of a permanent shift upward in growth and inflation, or whether it was simply a temporary sugar high induced by extraordinary, but now waning, monetary and fiscal policy. Over the summer months, it appears as though the sugar high contingent won out, as the 10-year Treasury rallied as much as 50 basis points (bps) from the local highs of 1.74%, placing the market in a candy coma brought on by weaker-than-expected growth, expectations of transitory inflation, oversold technicals, continued QE, and the surge in COVID cases.
As we begin to think about the forward trajectory, we are now armed with four more months of jobs and inflation data. And while we are sad to say goodbye to summer, we enter the fall with a better understanding of the labor market, though still trying to untangle inflation’s implication for Treasury yields.
Returning from summer vacation, the recent jobs data has brought some welcome clarity.
In our last blog, we built a framework for thinking about the pace of payrolls growth the Federal Reserve (Fed) would need to see to achieve “substantial further progress” in the labor market and subsequently taper asset purchases by year-end. We referenced June 2013, when more than 75% of the jobs lost during the global financial crisis (GFC) were recovered and the Fed first started to mention taper, ultimately cutting purchases 6 months later. To get to that level of recovery this time around, we needed a pace above 500k per month. Since our last blog in May, we have averaged 750k new jobs per month and recovered an additional 12% of lost jobs, raising the percentage recovered from 64% to 76%.
In line with the realized improvement in the labor market, this current Fed has similarly set the stage for a taper in the coming months. With inflation already meeting their assessment of substantial further progress and employment well on its way, Chair Powell has now endorsed tapering assets by the end of the year. Even with the August slowdown in job growth, our framework suggests that it would take a much more dramatic deceleration to derail the Fed’s plans.
Chair Powell has gone to great lengths to separate the criteria for tapering from tightening. As it relates to when rate hikes are appropriate, it will take another blog series to develop a framework for assessing the more ambitious hurdle of a “broad and inclusive” recovery that gets us to the Fed’s definition of “full employment”. In the meantime, we expect the Fed to remain incredibly accommodative, especially compared to prior cycles. Indeed, the market is not pricing the first rate hike until 18 months from now, even though the 4.5% unemployment rate that the Fed is projecting at year-end would be noticeably lower than where it was at the start of the last two hiking cycles in 2004 and 2015.
The chapter on the labor market, however, is far from finished. One curious phenomenon has been the surging supply gap with job openings rising much faster than employment. This has led to many questions about the structural impacts of the COVID pandemic. With all of the federal unemployment benefits expiring in early September, we are curious to see how much prime-age labor force participation improves in the coming months. A combination of rising wages, less government support, and the return of in-person schooling appears to be a strong cocktail that could encourage those on the sidelines to reenter the labor market. On the other hand, with levels of accumulative savings still elevated and a growing number of new COVID cases, it may take time to fully understand what the biggest drivers curtailing labor supply are and how long they will persist.
There are more questions than answers as it relates to inflation’s practical implications for Treasury yields.
Since out last blog, we find fewer solutions and more riddles as it relates to the interplay between inflation, inflation expectations, and Treasury term structure. The monthly increase in Core CPI has exceeded economists’ consensus expectations in 3 out of the last 4 reports. While much of the upside surprise has been driven by unsustainable automobile inflation, we have also observed healthy upward momentum in the cyclical and more durable shelter component. Even trimmed mean and median measures, designed to strip out volatility, are consistent with (or even above) the Fed’s mandate. Inflation expectations have been rising as well with the most recent release of the Fed’s Common Inflation Expectations measure (CIE) rising to 2.05%, the highest level since September 2014.
Despite these developments, the current term structure of the Treasury curve reflects a more pessimistic outlook and an inability to look through near term inflation noise to see the burgeoning medium term trend. As we reflected in our last note in May, the market was pricing the terminal rate below the Fed’s 2.5% estimate, sitting around 2.2%. Since then it has moved even lower, to 1.8% today. While we disagree with the negativity implied by extraordinary low long-end real yields and the flat term structure of rates, we are also cognizant of the factors keeping interest rates low, particularly global central banks’ large balance sheets and their continued QE programs. In addition, while we don’t see any clear evidence that productivity in the US has been impaired by the pandemic, it is still too early to make a definitive judgement.
Where does this all leave us? While it has been disappointing for those of us rooting for higher yields, our comments from May still ring true: “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.” As a result, we plan to buckle our seatbelts, since the rollercoaster highs and lows from the reopening, couple with continued sugary monetary and fiscal policy, are not likely to subside anytime soon.