The bond markets remain a central banker’s game. Europe and Japan are battling against too little inflation, while the US is assessing the timing of interest rate increases in light of low wage and price growth despite an improved economic backdrop.
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The anticipation of central bankers’ next steps will drive fixed income returns in the coming year.
The year is drawing to a close, but there is no peace for central bankers: they have inflation on their minds. The European Central Bank (ECB) is grappling with how to reverse the region’s deflationary spiral, and the Bank of Japan (BOJ) is struggling to reignite price pressure and, along with it, investors’ faith in Prime Minister Abe’s plan to invigorate the economy. Meanwhile, in the US, the economy is accelerating and more workers have found jobs, but the typical coincident increase in prices is absent. In Europe and Japan, the need for central bankers to buy more time is clear. However, in the US, the next step is less obvious. The Fed must move gingerly so as not to disrupt economic momentum, yet proceed quickly enough to avoid falling behind the curve and risking runaway inflation. The timing of the Fed’s next move will have considerable effects on global bond markets.
A two-pronged test: Part I complete, Part II to be continued…
The US economy has made great strides since December 2012 when Fed Chair Ben Bernanke pledged to keep interest rates near zero until the unemployment rate shrunk to at least 6.5%. At the time that Mr. Bernanke shifted to data-driven guidance, he noted that the original mid-2015 timeframe for a rate increase had not really changed. He surmised it would take unemployment at least until that time to reach the specified threshold, and inflation would likely remain close to 2% over that period. But after several years of stubbornly high unemployment, the labour market began to move and ultimately trumped Mr. Bernanke’s expectations: the unemployment rate blew past the target a year early.
“Lingering weakness in the labour market and below-target inflation are making the Fed hesitant about pulling the trigger on raising rates”
Despite labour market gains ahead of schedule, the Fed has yet to raise rates. There were two reasons for this decision: lingering weakness in the labour market and below-target inflation. Since taking the helm of the Fed, Ms. Yellen has voiced her commitment to keeping rates low until labour market slack wanes. She defined slack as unemployment due to a lack of jobs (cyclical unemployment), rather than because of a mismatch between available jobs and workers’ skills (structural unemployment). At the start of the year, slack was evident across several measures: high levels of part-time and long-term unemployed workers, low job turnover, declining labour force participation, and stubbornly slow wage growth.1 Fast forward eight months from Yellen’s speech concerning the Fed’s efforts to help people find jobs, and these labour market gauges tell a very different story. The U-6 rate, a broader measure of unemployment that captures part-time and marginally attached workers, though still elevated, is at its lowest level since October 2008.2 In fact, it is at a point where the Fed raised rates in 1994. (Figure 1) Job openings have surged 24% this year, and the quits rate reached a post-recession high of 2% in September.3 (Figure 2) With approximately two unemployed workers for every job opening (a historically normal level), unemployment due to cyclical factors seems to have abated. Much as is the case in the UK, the condition of the labour market no longer appears consistent with a zero interest rate policy.
With Part One of Bernanke’s mandate making the grade, the focus has shifted to below target inflation. Despite labour market progress, persistently low price pressure has bought the Fed more time to delay the first rate hike. What is the harm in extending stimulus if prices are staying stable? There is danger in complacency. Some of the drivers of low prices will be temporary, and there are reasons to expect at least some price pressure in the coming year.
Where is US inflation?
While prices were inching up in the middle of this year, they have softened in the most recent three months, and inflation expectations have turned sharply down.(Figure 3) Among the reasons behind subdued inflation are falling commodity prices (particularly for oil), only modest wage gains, and international developments impacting foreign exchange (i.e. a stronger dollar).
Oil prices have declined significantly since July, reaching levels not seen in 5 years. (Figure 4) (see our article “Oil: Will Saudi Arabia stay the course?” in this issue for a full discussion) Unsurprisingly, the Consumer Price Index (CPI) has been declining during the period as well. Lower oil prices equate to lower retail gas prices for consumers, which are factored into the energy component of CPI: energy comprises roughly 10% of the index, about half of which is gas prices. Even more interesting, however, is that core prices, which exclude the volatile food and energy components, also fell. So the question remains whether lower oil influences other domestic prices. The Federal Reserve Bank of Cleveland studied the correlation between the CPI energy index and the indexes for other CPI components to better understand this complex relationship. They found that the correlation between energy and other components is generally weak, in some cases, even negative. The two exceptions were food and beverage (which is excluded from the core calculation) and housing, though the strength of these relationships varied over time.4 Therefore, while oil can be at least partly to blame for weakness in headline CPI, softness in core prices is likely explained by other factors.
Since oil is volatile, it is difficult to judge how longer-term inflation will be affected. Lower oil may also exert positive pressure on prices over a longer horizon. As consumers use savings from lower energy prices for other goods and services, these prices are likely to rise, offsetting the initial negative influence. Around the world, particularly in Europe, cheaper oil is adding to disinflationary pressures and may result in more muscular action from the ECB next year.
The strength of the US economy relative to its developed peers warrants divergent monetary policy. The US is likely set to begin tightening in the coming year, while Europe and Japan are undertaking further accommodative procedures to spur their economies and generate some price pressure. The result: the dollar has appreciated considerably versus most other major currencies. The stronger dollar makes imports less expensive, limiting the ability of US producers to raise prices lest they risk losing market share. Slowing global growth has also put pressure on the prices of other commodities traded on global exchanges, many of which are trading in US dollars. Beyond the pass-through from imports, a recent study found that the trend of global inflation is a useful predictor of US inflation, meaning that the US is not immune from the headwinds of disinflation abroad.5
There is a reason for the dual mandate: employment and inflation are closely linked. As the labour market gets tighter, labourers can demand higher wages. Employers will seek to pass on the increased labour costs to consumers in the form of higher prices. This is especially true in services industries, where there is less international competition. In addition, more dollars in consumers’ pockets equates to increased demand for limited resources (i.e., inflation). Wage growth has been sluggish throughout this recovery, averaging around just 2% over the past three years, but this may be about to turn. November’s payroll report showed a 0.4% increase in wages versus the prior month (the biggest gain since last June).2 Also, a more comprehensive measure of compensation, the Employment Cost Index, has picked up over the past two quarters.59 This positive trend appears set to continue: the National Federation of Independent Business (NFIB) survey of small businesses showed that employers plan to increase wages in the coming months.2 (Figure 5)
As discussed, some recent disinflationary forces will likely abate going forward. Furthermore, the contribution from shelter, in the form of rent and owners’ equivalent rent (OER) should continue to be a positive driver of inflation. Vacancy rates are declining, pointing to upward pressure on rental prices.6 (Figure 6) Home prices should also continue to pick up as the labour market improves and increases the demand for housing. This sector should be sheltered from import price deflation from abroad, unlike other consumable goods. Price pressure in this segment has a significant impact on aggregate inflation. By far, OER has the largest relative weight of a single component in the CPI. Shelter accounts for 32 percent of the CPI basket, and OER represents about three-fourths of the shelter index, or nearly one fourth of the total CPI basket. (The other two main components of the shelter index are rent of primary residences, which comprises 7% of the total basket, and lodging away from home, which makes up less than 1% of the total basket.)7
We should not underestimate the inflationary force of continued labour market gains in a zero interest rate environment. The unemployment rate is approaching NAIRU, which is the point past which, economic theory suggests, labour market gains start to generate some inflation, and recent data points to continued improvement. (Figure 7) December’s Fed Beige Book showed labour market improvement across all twelve districts, and the November jobs report far exceeded expectations with payroll gains of 314,000.55
Global bond market outlook
With evidence of diminished slack in the US labour market, the Fed’s next move is largely dependent on the level and direction of inflation. The Fed must get ahead of inflation and move ;before pressure starts to build. A move before inflation hits the 2% target rate is a possibility, if there is evidence of prices moving in the right direction. In a recent interview with The Wall Street Journal, Fed vice-chairman Stanley Fischer made it clear that the period of low inflation due to falling oil prices will not deter the Fed from starting to raise rates next year.8
With deflation in parts of Europe and little faith in Japan’s inflation target, it’s easy to become complacent about price pressure in the US. But we caution against this view and expect the Fed to raise rates by the middle of next year, if not before. Bond buyers beware: yields will likely move up before the first rate hike is initiated. (Figure 8)
Monetary divergence between the US and the developed world will likely push yields in opposite directions. US yields are set to rise as the Fed moves forward with interest rate normalization against the backdrop of a better economy. Meanwhile, European yields are likely to be limited by the ECB’s expansionary monetary policy and positive bond fund flows in the region. Where possible, we favour shorter-dated bonds or income-oriented stocks over medium- and long-duration debt holdings.
Bond and stock investing involves risk including loss of principal. International investing involves a greater degree of risk and increased volatility.
1 Source: Federal Reserve: What the Federal Reserve is Doing to Promote a Stronger Job Market, as of 31 March2014.
2 Source: Bloomberg, as of October 29, 2014.
3 Source: Bloomberg, as of 30 October 2014 (Job Openings), Bloomberg, as of30 September 2014 (Quits Rate).
4 Source: Federal Reserve Bank of Cleveland: The Effect of Oil Price Declines on Consumer Prices, as of 19 November 2014.
5 Source: Federal Reserve Bank of Cleveland: Global Factors and Domestic Inflation, as of 25 September 2014.
6 Source: Bloomberg, as of 30 September 2014.
7 Source: Federal Reserve Bank of Cleveland: What’s up in inflation, as of February 21, 2014.
8 Source: Wall Street Journal, as of December 2, 2014.