Tampering with Tapering
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What You Missed: Long-term interest rates ended lower as equities remained steady for the week, balanced by mixed US economic data. The yield on the benchmark US 10-year Treasury note held at 1.56% as 1-month LIBOR and SOFR remained pegged at all-time lows. The price of a barrel of West Texas Intermediate crude oil jumped to a two-year high of $69.25 despite a planned production increase, as the US Dollar and Gold glided in their recent ranges. Treasury yield volatility, a key driver of the cost of rate caps and swaptions, traded steadily lower throughout the week.
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America’s sputtering jobs engine beat back inflation spooks. In what is always the single most influential piece of economic data on interest rates, May’s jobs report showed that the nation added 559k jobs last month from an upwardly revised +278k in April (two-month net revision +27K). A reduction in the labor force of 53K, driven by some opting for early retirement or simply choosing not to work, nudged the unemployment rate lower by 0.3% to 5.8%. Wages increased again by 0.5%, lower than the current rate of inflation, but above expectations of a smaller increase. Since the report dashed any near-term taper actions from the Fed, financial markets reacted logically; Treasury yields fell as equities rallied.
While 500K+ in job gains in a single month would normally be a huge accomplishment, coming out of a global pandemic where ~22.4M lost their jobs, America’s job creation performance last month was a disappointment. Generous unemployment benefits and natural limits on the pace of re-hiring almost certainly constrained job growth in some industries, as leisure and hospitality (+292k), other services (+10k), and retail (-6k) disappointed despite the rapid pace of reopening and a considerable easing of business restrictions. Among reopening categories, job growth was relatively strong in education (+144k, public and private), where the timing of school re-openings may be a more important consideration for the workforce than the unemployment top-ups. Job gains were broad-based but again well short of the March breadth (62.3% of industries vs. 74.7% in March). Also of note, manufacturing payrolls rebounded 23k, but federal (-11k) and construction (-20k) jobs declined.
Our take: The 559K jobs gain was at least an improvement on the paltry 278K gain seen in April, but with the level of total jobs still ~7.6 million below their pre-pandemic peak, it would take more than 12 months at the ~600K monthly pace to fully eradicate the shortfall. Said another way, it will take job gains of more than 1M per month to close the gap by the year-end. Only a few months ago we had expected to see several months’ worth of job gains north of 1 million as the economy reopened, but it seems that labor supply is bouncing back much more slowly than demand.
Looking ahead, job growth in the coming months will continue to bump against inertia on the part of potential workers who remain hesitant to rejoin the employment ranks. As solid as May’s job gains were, they pale in comparison to the stellar monthly gains over the same period last year, when the US economy was rebounding from the initial virus shock. With unemployment top-up payments winding down in half of states this month and ending entirely in September, we believe the April and May jobs numbers understate both the demand for labor and the pace of job growth possible later this year.
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Most importantly, as we have been saying for literally months now, the Fed’s #1 focus is getting America back to work. Neither of the last two jobs reports are consistent with the Fed’s self-imposed requirement of “substantial further progress” in the jobs market before they choose to ease off the stimulus throttle in any real way. Any near-term taper in asset purchases or a higher-rate path simply aren’t going to happen anytime soon, even if supply shortage-driven inflation persists. At the moment, we suspect the Fed will begin tapering asset purchases – nudging rates higher – in early 2022 at soonest. In the meantime, the Fed will brush off any ongoing overshoots of inflation, especially so if America continues to miss the Fed’s full-employment target.
What to Watch This Week: Brace yourself. Another red-hot reading of inflation lies in wait this week, on Thursday, via the Consumer Price Index (CPI). Since inflation is one of the fuels that could prompt the Fed into rate hiking action, this week’s data will demand everyone’s attention.
The CPI, which measures changes in the price level of a weighted average market basket of consumer goods and services purchased by households, will likely test 5% year-over-year in May, nearly double the long-run average and the highest reading since August 2008, as rapid economic reopening and supply shortages lifted prices. Don’t fall victim to the financial media prompting you to run for the hills though; we believe that the more prices rise this year, the faster they’ll fall going into 2022.
If we look back to last month’s CPI reading for guidance this time around, nearly 60% of the CPI’s monthly gain in April was concentrated in five post-lockdown categories: lodging, airfares, used cars, rental cars, and food away from home. It’s likely they’ll have little staying power long-term but will show up again in May’s CPI data as freshly vaccinated households scrambling for flights, cars and other categories experiencing high reopening demand are paying up amid supply shortages. Expect this dynamic to persist for several quarters or even longer.
Other data this week will bring a fresh read on jobless claims as workers in half of U.S. states receive their last few augmented payments before these benefits start expiring in the middle of the month. Elsewhere, the University of Michigan will provide the latest read on whether inflation expectations moved up further in the first half of June on the back of accelerating prices.
We won’t hear anything from the Fed this week; its pre-policy meeting blackout period will prevent policy makers from discussing the latest data implications for their economic outlook until the conclusion of their next rate-setting meeting on June 16.
Big Picture: Still hung up on inflation? Still hoarding gold? Don’t bother. Travel and entertainment-hungry consumers, having accumulated a hefty savings cushion during the pandemic, will remain relatively indifferent to price spikes across goods and services over the summer months. We don’t know about you, but we’re dying to get on the road, and we suspect many like us feel the same way. For the average consumer though, the fact that wage growth is lagging inflation will eventually hit them in the face by limiting their purchasing power when economic growth subsides to a more sustainable pace toward the end of the year. As a direct result, the waves of inflation we’re surfing now and through the fall will eventually subside into 2022. The Fed’s slow, measured approach toward pulling back the stimulus punch bowl is the right one, and any upward move on rates will be limited over the summer and fall.
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Source: Bloomberg Professional
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Source: Bloomberg Professional
