AWE Wages Picture is Worse Than It Looks; Why Is The Curve Still So Flat?

“Down Goes Frazier! Down Goes Frazier! Down Goes Frazier!” --Howard Cosell

I used to have a colleague that would giddily exclaim, “Down Goes Frazier!” anytime he was short a bond that flashed, “HIT” on the broker screens. Since he was pretty good at his job, it became so ubiquitous on the desk that it was easy to forget where it originated.  

Those of us that grew up in the 90s remember George Foreman as a lovable middle aged man that made a living beating up mediocre boxers and selling indoor grilling equipment. But in the 70s, he was a total badass. Foreman pummelled the champ into virtual submission, knocking him down six times before the ref stopped the fight midway through the second round.   

So that was the phrase that went through my head when I saw that negative NFP print. The unthinkable has come true….A seven year streak of positive prints is over.

An awful number, even looking through the noise from the hurricane? Not by a long shot. UE continued lower, indicating there was no easing of labor market conditions. More importantly, average hourly earnings grew faster than expected, and continued a trend higher that has been intact since early this year.

I’m always a little suspect of YoY numbers since they are by definition dependent on what happened a year ago--a look at annualized AHE over the last three months, seasonally adjusted paints a rather surprising picture:

.

Pretty clear picture there. Three periods of recent history--2010 to 2015, when wages bumbled around 2%....2015 to early 2017, when they bounced around 2.5%. Now one could reasonably infer wages are set to find a new range at or above 3%.

And yes, the Fed has hiked interest rates, and has the torpedoes armed and ready to deploy in December. Yet the curve remains amazingly flat--no doubt in part because of this year’s low headline inflation prints implying we may be near the end of the economic cycle. But with the recent prints in payrolls/wages and some good arguments for why headline CPI is understating financial conditions, seems like 2/5s should be a little closer to the steeps than the flats, when there is little evidence the Fed is going to waterboard the economic recovery with an aggressive hiking cycle.

And we all know what USD has done this year--until the past few weeks anyway.

Why does the curve refuse to steepen?  This chart is from Kashkari’s diatribe last week. The FOMC’s most dovish voice says,

“I believe the most likely causes of persistently low inflation are additional domestic labor market slack and falling inflation expectations…..I will argue that the FOMC’s policy to remove monetary accommodation over the past few years is likely an important factor driving inflation expectations lower.”

I think the above evidence takes an ax to the first leg of Kashkari’s labor market argument. And the second? The clear implication is that the combination of tapering asset purchases, hiking rates, and eliminating SOMA re-investments (that is, reducing the balance sheet) has over-tightened monetary conditions.  

I think Kashkari has misidentified the source of lower inflation expectations. Market-implied inflation expectations fall by definition when there are buyers of nominal rate bonds relative to inflation linkers.  Without kicking the hornet’s nest of term premium arguments, the NY Fed’s ACM term premium model shows a steady if unspectacular increase in short-term forward rates with the term premium still solidly in negative territory.  

Source: New York Fed

The bottom line is that there is a ton of demand for assets relative to the marginal propensity to consume. Global investors want to buy more long-duration assets relative to the quantity being issued by either the government, or corporate borrowers, forcing down future returns.  That doesn't foreshadow lower inflation. It illustrates easy financial conditions.

That demand for assets extends not only to foreign corporations and individuals, but also to central banks. Remember a year ago when smart people we saying there was a floor below which the PBOC’s foreign reserves could not sustainably fall? If it ever existed, it is nearly $100 billion in the rear-view mirror now.

And the Chinese aren’t the only ones--the US current account deficit combined with resurgent manufacturing demand has put foreign central banks into overdrive to limit the appreciation of their domestic currencies. Foreign central banks have purchased roughly $200 billion of treasuries this year.

One might think that reflected a global interest in buying US Treasuries--but foreign private investors have added a modest $24 billion this year. Any chance that money is going into spread product???

Which brings us nicely back to this:

The Economist gives us about one of these per year. It just shouts out “contrary indicator”. Twitter practically had kittens.

Take the time to read through the article, it’s actually pretty good. They go through a number of arguments for how we got here and what might happen next. Only one did I find rather dubious--the suggestion that we are near the endgame because there are more people in developed markets starting to retire, and as they burn off assets real interest rates will be forced to rise.

That ignores billions of people in emerging markets. Not only are they in a better demographic situation--they are living longer as their standard of living increases.

A recent paper by the San Francisco Fed shows that it is actually life expectancy rather than demographics that has driven real rates lower over the past thirty years.That means as people in EM countries increase their living standards, they are not only making more money, they are hoarding more of it in anticipation of living a long and fruitful life, which pushes global real interest rates lower. More on this subject later this week.

We can parse this market in practically any way we like--bemoaning the lust for cov-lite, sub-investment grade bonds,  Argentine bonds with comically long times to maturity,  levered short vol positions, or private equity, but at the end of the day there is a ton of money chasing assets, and not enough scary stuff happening in the world to convince them to change course.

History tells us these trends don’t end well. But we don’t know when the music stops. The Fed doesn’t want to be the villain that breaks the market--but there’s a ton of evidence I’ve noted here that argue financial conditions are too loose, and even by its own measures, core inflation isn’t telling the whole story.  I just can’t get away from the memory of 2004-2006, when the fed hiked 25bps every meeting for three years and still armed the greatest financial weapon of mass destruction history has ever seen.

To the Fed Governors...I know you guys love your jobs but look at your own numbers...to borrow from Reagan…”Doctor Yellen, Steepen this Curve!”

Shawn
TeamMacroMan2@gmail.com

@EMInflationista