“Pour myself a cup of ambition … and they never give you credit“
Dolly Parton, 9 to 5
In our last piece, we discussed what we see as rising disparity between the DM monetary stance and the underlying strength and or stability of domestic demand. We highlighted what we see as ‘distortions in the ‘basket of goods’ that collectively form the underlying basis of the inflation calculation. Suggesting that there is a significant amount of substitution or foregoing of goods - in some instances in order to enjoy services in others, questioning affordability. Thus, if large numbers of consumers have switched or foregone items in the ‘basket’ calculation, then the ‘basket’ that informs the CPI numbers may well be significantly overstating underlying demand - and thus the need for tighter monetary policy. Most obviously in the UK.
We also discussed the view that there remains significant price distortion from the energy price shock. We noted that in the UK, the government energy price cap (which likely limited the extent to which headline inflation rose in the first instance, is also likely the major protagonist delaying the decline) only ever applied to households; businesses had to negotiate directly with energy providers. The result was a wave of very big jumps in underlying costs to manufacturing and service sectors businesses that forced prices higher by default, but likely roll off the comparison over coming months, a factor we feel may not be reflected in services inflation expectations.
Ultimately, we concluded that given the size of the shocks that we have seen on the demand and supply side as a function of the pandemic, it is not out of context to suggest that the economic growth backdrop (especially in the UK at the current juncture) is weaker than the current data suggest – nor that DM central banks are behind the curve on inflation.
This week’s data and narrative has added to this debate. After a slow start to the week, distorted by the US Independence Day holiday, activity started to pick up with the minutes from the June Fed ‘pause’ meeting. The minutes themselves brought very little new to the table, especially when put into the context of the updated dots and SEP’s at the June FOMC. Essentially, the focal point of much of the analysis was the reference that “almost all participants judged that keeping the federal funds rate unchanged was appropriate or acceptable, while some preferred or could have supported a 25bp hike in June”, whether in the context of a hawkish split on the committee, or a more hawkish bias. However, it is only reflective of the balance of ‘dots’ issued at the June meeting, no more.
The second focus was the clear statement that “a further moderation in the pace of policy firming was appropriate”. A reflection of a desire to further assess the cumulative impact of previous rate hikes and tightening of financial conditions via other means (notably through the credit channel from the recent ‘small bank shock’). While Powell pushed back against the notion of ‘every-other’ meeting policy moves, markets continue to interpret the ‘pace’ reference from the Fed to mean alternate meetings. If this proves to be the case, then a July 25bp hike would infer November as the next ‘live’ policy meeting.
We view the prospect of the Fed still hiking rates in November as a very low probability, given the fact that rates are already in restrictive territory, demand and supply continue to come into better balance across the economy, and inflation pressures are falling as growth moderates. Market pricing at the front end of the US curve suggests that while there is a significant inflation risk premium, consensus appears to concur (22bps priced for the July meeting and a further 14 in November).
While the front end of the US yield curve (or the strip) could be described as well behaved in this regard, inflation risk premia and likely to a greater extent market positioning in the sovereign curve are far more volatile.
At the current macroeconomic juncture, monetary policy and more specifically the end of the tightening cycle is the dominant factor across asset classes. As markets look for a turn in the cycle, US duration longs (long US bond positions) grow. However, the Fed and other DM central banks have been very clear that policy is increasingly data dependent at this stage of the cycle, and thus the volatility of the most recent economic data transfers directly into volatility in the US curve. Perhaps an illustration of the rule of thumb in financial markets that volatility is high at turning points. This week has been a very clear case in point.
Essentially the Fed has a dual mandate - price stability and maximum employment (each with equal primacy in law as Powell was keen to point out at a recent press conference). Thus, it is not surprising that the data on US jobs and inflation dominate the debate. We will have to wait until next week for the inflation data, but this week has been all about jobs.
To briefly summarise the three key releases (JOLTS, ADP and NFP), the data continued to offer the view that the labour market remains tight. However, following on from our thoughts of last week, we are not convinced that it is as simple as that.
The JOLTS data which is viewed as a barometer of the ‘jobs gap’ in the economy or the excess demand for labour (and thus an indication of potential wage pressure) eased in May. The drop was perhaps not as much as some had hoped for, but it was more than analysts expected.
ADP, the private sector payroll report, always released just before the more ‘important’ NFP data, showed surprise strength in the month of June. However, there are a couple of factors that are worth considering in relation to the print. The first is that the ADP has underperformed the NFP for a while (a factor referenced by the Fed in this week’s minutes - ‘alternate measures’ of labour market activity) and there is a suggestion that the seasonal adjustment distortions over recent years (a point we have raised in previous pieces) mean that summer jobs for students may be distorting the data to the topside.
NFP gains were more moderate, perhaps suggestive of a better seasonal adjustment, and offer some suggestion of a cooling labour market as tight policy cools demand growth. A modest upward revision to the AHE number for May, and an unchanged level in June will give those on the Fed that are inclined to do so, an element of hawkishness - if increasingly on a weaker footing.
In the UK this week, the distortions or volatility in the bond markets have been even more pronounced, as participants stop out of long duration and others seek protection from the prospect of higher rates from the Bank of England. Our views remain unchanged from the more detailed discussions of last week - that the UK economy is not as strong as the current data may suggest and continue to subscribe to the Tenreyro view that the more UK rates rise now, the more they will need to be cut later. A very difficult backdrop for UK mortgage rollovers at the moment, only adding to the stress of high prices and high taxes.
After the significant distortions of the past couple of years, especially in terms of supply (notably labour) it is perhaps not surprising that, even as the economy slows, labour metrics continue to remain relatively strong. We would argue that a) this is catch up to the pre-Covid trend and b) that this is not likely to be inflationary.
While many consider an increasing number of “folks… on the job from 9 to 5” is likely to lead to wage and price inflation persistence, we disagree. Our view is that credit and debt should be more of a focus from here, with very different policy implications. With payroll growth at just 200k in June and CPI close to 3% - the case for a more hawkish Fed remains weak in our view.
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FOMC Statement, 14 June 2023: https://www.federalreserve.gov/newsevents/pressreleases/monetary20230614a.htm
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