Please note: this piece is based on the work of Wellington Management; a U.S. based sub-advisor of SLGI Asset Management Inc., and therefore is written from a U.S. perspective.
- Inflation dynamics appear to be shifting from demand-pull1 to cost-push2, evidenced by the most recent disappointing non-farm payrolls release.
- The U.S. government response and structural changes to the economy as a result of COVID may make the Fed’s employment goal unattainable.
- We observe opportunities to capitalize on changing inflation dynamics across global rates and currency markets.
May job gains for U.S. non-farm payrolls fell well short of market expectations in April. It is possible that this was just a coincidence, that future job growth may rebound, and the market narrative may shift again. However, I think it is a mistake to dismiss April’s job numbers out of hand and they could be indicative of underlying structural issues. The key debate is whether the rise in prices that companies and consumers are experiencing is demand-pull or cost-push in nature. Obviously, it is both, but I do think that this jobs report shows that we are slowly moving from demand-pull to cost-push inflation. In the U.S., there is currently a large gap between those collecting unemployment benefits and the headline unemployment rate, with those receiving unemployment insurance benefits at the highest level it has ever been.3
The gap to me demonstrates the side effects of the massive fiscal stimulus. that the U.S. has pursued after COVID. Unlike any other recession, the government not only filled the void in disposable personal income, but actually increased it above its trend. Policies like this naturally lead to higher levels of structural unemployment.
This may resolve itself when unemployment benefits end in September but it might be politically difficult to do so. Peak growth is likely going to be reached this summer as the economy reopens, and eventually this pent-up demand may fade, at which point it may be difficult for fiscal authorities to cut unemployment benefits. While we may likely get more fiscal stimulus, unlike the other COVID-related stimulus. plans, the proposed spending takes place over many years with a plan to pay for it. The implication to me is that labour supply is a lot tighter than it historically has been at this level of the unemployment rate and we are starting to transition more aggressively away from demand-pull to cost-push inflation.
Cost-push inflation could be more harmful for an economy than demand-pull as it forces companies to take three distinct (and all poor) options:
- Cut capital costs elsewhere to preserve margins
- Invest in labour-saving capital
- Pass costs on to consumers in the form of higher prices.
None of these options is very good for corporate profits. If a company tries to cut capital expenditure, it may preserve margins over the short-term, but over the long-term, this leads to lower structural growth rates for the economy as a whole. Given the low levels of non-residential investment in the U.S., I’m not sure that these levels can be cut any lower so I am skeptical this is the route that companies can take. Another possibility is that companies may see rising wage costs and invest in automation that might raise productivity and structural growth rates – I am skeptical that this may materialize. The companies at the base of the supply chain (basic materials, energy) have all learned over the past decade NOT to increase capacity regardless of price. The trend of capital flowing away from Environmental, Social, Governance (ESGI)-unfriendly sectors may also exacerbate this trend.
Potentially, the likely scenario is that companies may try to pass costs onto their consumers; this causes broad inflation for the economy, but also affects growth. Higher inflation does change consumer behaviour and can lower demand. For example, given current lumber prices, households are going to push off home renovations. One might think that in an industry like technology with substantial monopoly power there are such large barriers to entry that they can easily pass their costs onto consumers. While these companies have more ability to do that, it still may affect demand if marginal costs start to outweigh marginal revenue in areas like ad spending. This is another way of saying cost-push inflation causes slower real wages, changes consumer behaviour, and contributes to lower overall real growth.
If the U.S. economy is slowly entering a phase that may be more subject to cost push inflation because the non-accelerating inflation rate of unemployment (NAIRU) is higher than it was before, what does this mean in terms of monetary policy? The Fed has indicated it believes the Phillips Curve (relationship between unemployment and wage growth) has flattened and therefore there is no reason to believe that significant inflation pressures may result from low unemployment. According to the Fed’s revised monetary policy framework, in order for the Fed to hike rates, they may need to observe both very low unemployment AND inflation above 2% for some time period.
It is for this reason that despite all the questions that the Fed is getting about inflation, they insist that it is likely going to be transitory but if it is not, they have the tools to contain inflation. It is worth examining both of those questions separately.
How will the Fed know if inflation is transitory? Two ways: time or market expectations. Following the latest print which widely exceeded market consensus, core inflation is rising 3.0% year-over-year – well above the Fed’s target of 2%. Over the next few months, the Fed expects this to continue largely because of base effects, but then revert to the target. If the Fed is using time to determine whether inflation is transitory that would take another year or so after the base effects wear off. Based on this framework, the Fed would not consider raising rates until 2023 at the earliest. This is consistent with market pricing that has less than two Fed hikes priced (at 43 basis points) over the next two years.
The Fed could also determine whether inflation is likely to be transitory by monitoring market-implied inflation expectations. Once again, there are no warning signs at present for the Fed. The five-year forward five-year inflation expectations were at 2.49% as of 12 May 2021, which, given some differences between how inflation is measured (PCE versus CPI), is roughly consistent with longer-term inflation expectations still being relatively well anchored. However, even if forward inflation expectations start to rise toward 3%, the Fed’s new policy statement effectively implies the Fed will remain on hold because the unemployment rate remains well above pre-COVID levels. Fed chair Powell consistently mentions the Fed’s desire to return to the employment environment that preceded COVID. The government response and structural changes to the economy as a result of COVID may make that goal unattainable.
The second question is also interesting. Does the Fed have the tools to combat high inflation/inflation expectations? I do think they have the tools, but they are extremely unlikely to use them based on their recent statements, political considerations, and their new policy statement. If inflation starts to get out of hand, the Fed may not raise the policy rate until 2023, but they could start tapering their QE purchases. For context, Bernanke started talking about tapering in 2013 when the unemployment rate was 1.4% higher than it is today, yet Powell insists that it is not yet time to “start talking about talking about tapering.” For some reason, the Fed at various. times has tied their reduction in asset purchases to the liftoff from the policy rate. When asked about when they will taper their balance sheet, Powell routinely answers, “when we have made substantial progress to our long-term goals as outlined in the recent framework review.” In a way, the Fed is trying to figure out the appropriate time to hike rates and then subtract some time before then to start tapering asset purchases. Perhaps these are just words and the Fed will separate the rate decision from the balance sheet decision, but short-term political considerations make that difficult.
Powell’s term ends in February 2022, but the real deliberations for Fed chair take place in the fall, with an announcement likely in November. I think it is very unlikely that Powell gets another term, but it is clear that he does want one. If you are trying to keep your position as Fed chair when massive stimulus is still expected to come down the pipeline, it behooves you to not taper your purchase of government debt. For this reason, I think that the Jackson Hole Economic Symposium in August is too early for the Fed to start talking about tapering. The recent poor jobs report gives Powell the political cover he needed to delay the decision about tapering. Let’s imagine that Powell doesn’t initiate the conversation about imminent tapering in Jackson Hole but finds out in November that he will not be the next Fed chair. He will have a very limited time period with which to set policy for the next Fed chair, likely Lael Brainard. One of the reasons that Bernanke introduced tapering when he did was because he did not want to force the next Fed Chair, Yellen, to have to immediately make that decision. If Powell thinks similarly, the Fed balance sheet might continue to grow a lot longer than we think.
Finally, it comes down to the new monetary policy framework, which effectively subordinates the Fed’s inflation mandate to its maximum employment mandate. The Fed does not believe that the Phillips Curve is steep, and NAIRU is high. In other words, the new policy statement communicates how the Fed should act with demand pull-inflation, but is silent on cost-push inflation. The reason for this omission is that the Fed thinks they know how to solve cost-push inflation i.e. the higher interest rates that were engineered by the Volcker Fed. But hiking rates during stagflation is an extremely difficult policy decision to make. Volcker was demonized by both political parties and there was a reason he was the first Fed chief with a full security detail. Will Powell or his successor have the grit to raise rates when the labour market is not remotely close to where it was pre-pandemic and inflation is no longer transitory? Maybe, but the market may likely test them on that assumption first.
Effectively the Fed is trapped. They had a very limited window this summer during the reopening to taper their asset purchases and prepare the market for eventual rate hikes. This jobs report is the nail in the coffin for this because of their revised policy framework.
Opportunistic Fixed Income fund investment Implications
We have been negative on the U.S. dollar for a few years now; I do think that this jobs report could be the catalyst for a further move lower in the dollar. There are three reasons to be negative on the U.S. dollar – an expensive real exchange rate, rising current account deficits, and Fed policy.
Real exchange rates – Policies enacted by both administrations in response to COVID have raised unit labour costs (ULCs) substantially above productivity and current policies only exacerbate this further. Perhaps by artificially creating a tight labour market, we could see companies invest in CapEx, which may eventually cause productivity to catch up. I am very skeptical of this for the reasons above. And as such, when ULCs exceed productivity, the real exchange rate for a country becomes overvalued, which is increasingly the case in the U.S.
Current account deficits – A current account (CA) deficit is the difference between a country’s national savings and investment. In the U.S., the monthly goods deficit is reaching an all-time high. Recently, even the petroleum products deficit has turned negative as the U.S. is no longer a net exporter of petroleum products. Ironically, the U.S.’ progress in vaccination means that reopening is moving ahead of other countries and this spending is likely going to increase this deficit substantially in the short-term, which could lead to a weaker currency.
Fed policy – The Fed’s revised policy statement as well as short-term political considerations indicates that they may be one of the last central banks to taper. Combine this with fiscal policy that has dwarfed other countries, and it seems like an ideal environment to be short U.S. dollars. We are currently short the USD with an emphasis on EM and other low-carry DM countries like the EUR and JPY.
When thinking about how rates are going to react, it is important to first determine what has been moving rates in the first place. While inflation has made the headlines as influencing the bond market (and certainly has at the front-end of the curve), most of the rise in forward yields has actually not come from inflation expectations but in real yields4. The reason that I think forward real yields rose in Q1 rather than inflation expectations is because the term premia needed to normalize. You can think of the term premia as the excess yield compensation one should demand over the likely path for the policy rate, because of uncertainty associated with holding longer-dated bonds. COVID has certainly caused a tremendous amount of uncertainty in both the inflation and real growth outlook.
But now, we are at an interesting point. I believe that if rates were to rise from here it may not come from the term premia like in Q1 2021, because in a lot of ways economic uncertainty is going to decrease over the next year as we understand what the reopening may look like. Instead, rate increases may likely to come from forward inflation expectations. So even if we do not think the Fed is tapering any time soon, this dovishness could be met with a steeper curve via the inflation expectations channel. This is the reason that 10y Treasury yields sold off on May 7th after the poor jobs report.
If rates were to rally, I think it may probably come from some normalization in the term premia and also less enthusiasm for the reopening trade. The 10yr yield has been very strongly correlated with COVID losers outperforming COVID winners since the crisis began5. If we are in a cost-push inflation world, then the COVID loser sectors could be in trouble. While there may be a lot of demand for their services, the workforce in the hospitality and restaurant industries were also some of the lowest paid workers who have disproportionately benefited from government stimulus. It is likely that margins for these companies could be squeezed right at reopening because labour is not available.
Accurately forecasting the direction of U.S. nominal bond market is extremely tricky right now and I don’t have a lot of conviction. Being non-benchmark oriented total return investors, we can scour the globe for duration markets that we think are more compelling.
Long-end U.S. real yields – 30 year U.S. real yields probably do not look very cheap to many at -3bps; however, if we are right that the next move higher in rates is going to come from inflation expectations then these bonds could potentially outperform U.S. nominal bonds. As I mentioned, I believe that inflation may not be transitory this cycle, but there is a reasonable probability that cost-push inflation may weaken demand enough that it tempers the rise in short-term inflation.
Non-U.S. duration markets – The U.S. is no longer the cleanest dirty shirt, but the dirtiest dirty shirt. There are a number of government bond markets where both the monetary and fiscal authorities are acting with prudence. We have been increasingly selling our U.S. treasuries and buying duration in countries like Canada and Norway, who have already tapered or did not do Quantitative easing in the first place. If we are right about the U.S. dollar depreciating, these countries currencies could continue to appreciate with further negative effects on domestic inflation.
Emerging Markets (EM) local bonds – One of our largest sources of duration is in EM local bonds. Much like the developed world, EM countries are currently dealing with higher inflation prints caused by base effects, higher commodity prices, and broken supply chains. In addition, EM central banks have noticed the substantial rise in U.S. real yields and have accordingly decided to suspend their rate cuts or even increase the policy rate in countries like Brazil and Russia. We believe this inflation is likely to be temporary, and that many EM countries are making a mistake by hiking policy rates when their output gaps are truly wide. EM countries have seen the rise in forward real yields and adjusted their policy stance prematurely, largely to protect their currencies if there is Fed tapering. I do not think this is likely to be the case, but even if it is, EM countries’ financial positions are in much better shape than during the taper tantrum in 2013 with cheaper currencies, positive current account surpluses, less imports, and ample reserves. Our largest holdings in which we like both the currency and the rate markets are Mexico, Russia, Brazil, and Indonesia.
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1Increase in aggregate demand, categorized by the four sections of the macroeconomy: households, business, governments, and foreign buyers.
2Decrease in the aggregate supply of goods and services stemming from an increase in the cost of production
3As of 31 March 2021. Sources: Bloomberg, Wellington Management
4As of 10 May 2021 | Source: Bloomberg
5As of 10 May 2021 | Sources: Bloomberg, Wellington Management