DPAM Blog

STATE OF AFFAIRS

• • Many students are facing a series of exams over the month of June. If you were to submit to students in economics questions on the behaviour of bond markets the moment US headline inflation hits 5.00% and 3.8% for core inflation, I reckon few would respond with confidence that US Treasuries would rally aggressively, shaving about 10bp from 10-year rates. Yet, that was the outcome: 10-year US rates dropped from 1.55% towards 1.45% over the week. What’s going on here? Again, several market strategists point to a technical short-covering counterrally. Others mention the continued rebalancing of pension funds towards US Treasuries, as most of them achieved funding levels close to 100%. “Better safe than sorry”, many pension boards must shout, and demand for long-end US Treasuries and long US strips remains high and persistent. However, the former is inherently short-term, and the latter loses intensity. Fact is that a growing number of participants tentatively start to agree with the temporary nature of the US inflation surge. Interestingly, the US experiences, again, an exceptional condition. Indeed, inflation numbers in Europe have hit 2.00%, a far-cry from US levels. Sweden posted a 1.8% print for YoY inflation in May. China impressed on PPI with a print of 9.00%, but inflation disappointed somewhat at 1.3%. At the end of May, global inflation sat at 2.7%. Such a number was present over 2018-2019. Consensus sees global inflation falling back towards 2.2% to 2.4% by year-end. But, if the ‘too high for comfort’ inflation condition is temporary, we should pay attention to other indicators. Today’s message centers around the elephant in the room called labour market recovery. Today’s inflation debate might be the wrong debate in relation to the shape and the level of US rates. The debate should shift more towards the shape of the US labour market recovery and impact on US rates.

• • The US labour market recovery after the Great Financial Crisis of 2007-2009 was highly protracted and the unemployment rate only went below 5% during 2016. Over March-April 2020, more than twice as many jobs were lost. Over the summer of 2020, about a third of the job losses was recalled. The US boasts a high economic growth recovery pace and unemployment has dropped to 5.8%. Suddenly, the last two non-farm payroll (NFP) numbers disappointed and the US is still about 7 million jobs away from the levels witnessed at the end of 2019. From past recessions, we observe that three issues require attention when employers are faced with high unemployment conditions. First, companies have more trouble choosing which new employees to hire. Second, employee rotation in sectors less hurt or even profiting from the pandemic is rising, creating longer lead-times in seeking apt replacement. Third, bank lending recovers slowly the moment certain sectors want to expand their operations as uncertainty remains high. The first two issues relate to skill mismatches that, at present, occur across winning and losing sectors. Moreover, the most impacted sectors (leisure and hospitality, retail trade, entertainment and recreation) might see a larger share of permanent job losses. The labour market structure made a transit towards more service-related jobs than goods-related jobs. Scarring is deep in low paid servicing jobs. Temporary layoffs will become permanent. Hordes of people that currently enjoy high unemployment benefits might have a nasty awakening once they try to re-enter the workforce. The point I make is that in order to close the labour force gap in a qualitative fashion, with proper pay, we might have to pencil in a longer timeframe.

• • We require about a gain of 300k a month on non-farm payrolls (NFP) over the next two years, to reach Q4 2019 employment numbers over the summer of 2025. Under a scenario where, on the one hand, small and medium enterprises in their struggle for survival decide not to hire or hire less, and, on the other hand, the superstar firms, aiming for higher productivity levels, hiring more slowly as well, the above two year timeframe might get stretched. Platform-based, network dependent business models are adopting telework as part of the contract package, thus saving on labour costs and total required FTE’s. Under a +200k average monthly NFP gain we make good on 7 million jobs by the summer of 2026.

• • The US Treasury market is aware of this. Such an outcome, closing the labour gap by 2026, would leave the US Fed less room to tighten monetary policy. Reaching labour market normalisation will control the path towards policy normalisation. The Fed has prioritised maximum employment in the treatment of its threefold mandate. Steady growth is achieved by collaborating well with the Treasury department, rolling out a yet-to-be-determined fiscal policy. Inflation becomes residual. The unofficial fourth objective of financial market stability might be reached under the known gradualist approach, including a light-switch conduct in the use of the QE weapon. The previous interest-rate cycle took three years (Dec 2015-Dec 2018) and lifted policy rates towards 2.5%. The future might confront us with a sequence of lower lows. The interest rate hiking cycle ahead of us might ‘only’ stretch to 1.5% or 2.00% as we mentioned in past weeks. That might explain why US 10-year rates broke the 2-month-old 1.50%-1.75% range. The moment the market switches the inflation narrative in exchange for the labour market recovery narrative, we might step into a 1.25% – 1.50% range for US 10-year rates.