Last Week Another crazy week in a wild year. We spent the first three days of the week ratcheting up the odds of the potential of a faster Fed taper and earlier policy rate hikes, then we spent the da...
Dead Man's Curve, it's no place to play
Dead Man's Curve, you best keep away
Dead Man's Curve, I can hear 'em say
Won't come back from Dead Man's Curve – Jan & Dean
The yield curve was certainly no place to play last week and it remains treacherous as we approach the Federal Reserve’s FOMC statement and press conference this Wednesday. The specter of wage-growth inflation taking the baton from supply-shock inflation is now front and center as investors begin to price in a more aggressive Fed in 2022. Based on what the Eurodollar curve and Fed Funds Futures curve tells us, the market has begun to price in two Fed policy rate hikes in 2022, starting in June. These curves had signaled no Fed hikes in 2022 as late as September 30, 2021. Meanwhile, inflation breakeven rates steadily advanced throughout October. As of September 30th, the five-year breakeven rate implied an inflation reading of 2.54%. On Tuesday last week that reading stood at 2.98%. If we consider that inflation expectations are front-loaded, a five-year rate of nearly 3% is calling for a persistently high rate of inflation in 2022 and perhaps 2023.
On Friday, the Bureau of Labor Statistics Employment Cost Index (ECI) was released for the third quarter. The BLS reading rose at a record pace, smashing most economists' estimates. Furthermore, over the weekend The United Auto Workers Union at John Deere & Company appear to have received what they were demanding when they walked off the job a few weeks ago. While the agreement is not ratified, the union was able to secure a 10% wage increase immediately, with further increases in the future as well as cost of living adjustments. It certainly appears that, after decades of wage stagnation and rapid decline of union employment, the tide may be turning.
This news on inflation and the subsequent pricing in a more aggressive Fed caused a sharp flattening of the yield curve with the thought being that the Fed “will do the right thing” and squash inflation over the next year or two and leave the longer end of the curve in its continued state of zero inflation bliss. Interest rate volatility exploded, with some swaption volatility measures such as two-year, one-year (one-year swap rates in two years) increasing 36%. These sudden and sharp developments caught a few large macro-hedge funds wrong-footed (probably in some form of yield curve steeping and short rate volatility), causing much of the wild price action we saw in the yield curve and rate markets option volatility as bad positions were closed out.
While the markets are now pretty convinced that the Fed will be active in 2022, I am not so sure. From a policy standpoint, the Fed has developed a broad tool kit of measures to supercharge demand. However, for the supply side shock, other than the blunt force of rate hikes and balance sheet operations to crush demand, what else does the Fed have? Unless they can print a global labor force the way they print money, they really do not have much.
Moreover, for the first time in decades, the Fed is really at the crossroads of their dual mandate to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.” Stable prices and low-to-moderate interest rates over the last three decades have been fabulous for financial assets such as equities, G-7 government debt, investment grade and high yield corporate debt, and emerging market equity and debt, just to name a few. The main reason for market prosperity has been the offshoring of millions of American jobs.
You don’t have to do much head-scratching to realize that labor is still the most important input to the price of goods and services. For every winner, there is a loser, and the loser has been the American worker. If you are trading the markets, you have to recognize, for the first time since the 1970s, the Fed is going to have to make a fundamental decision. Do they lean into price stability or broad economic growth which includes wage inflation? Most traders and investors have only seen a Fed protect financial assets, not necessarily by conscious choice but more from the fact that the Fed does not write and enact global trade agreements or tax policy. They really haven’t had to worry about inflation because first Paul Volcker’s Fed smashed it in the early 1980s and then a succession of Presidents and congressmen from both political parties essentially buried it with free trade agreements and little in the way of tax policy to stem the tide of offshoring labor.
Since 2010, the end of The Great Recession, the S&P 500 is up 313% and the NASDAQ is up 586%. Meanwhile, according to the St Louis Fed Corporate Profits (without Inventory Valuation and Capital Consumption Adjustment) have increased 77% since 2010. Over the same period, the Employment Cost Index for Private Industry Workers has increased only 33%, and that ECI statistic is a broad measure that includes all private workers. If we were able to look at wages for workers at the bottom of the scale, we’d find that their wages have hardly increased at all until 2021. The Federal Minimum Wage has not been raised since 2009, and while many states have enacted higher minimum wages since 2009, until very recently, a big chunk of hourly non-union workers have generally fallen under the category of “working poor."
Are the millions of working poor, whose ranks have swelled over the last three decades concerned about inflation? Of course, they are. However, is the family with both parents working full time and still unable to put $400 together for an emergency going to scream to Jay Powell to raise rates sooner rather than later to squash inflation. I am going to make a wild guess and say no. What they are going to do is demand higher wages to keep pace with the rising cost of living. Corporations whose profit margins have consistently expanded can either eat the rise in labor costs and reduce profit margins or they can pass it on. Passing it on is the easy and logical answer if your management horizon is the next earnings quarter. However, eating some of it might be a long-term better answer as it could dampen the wage inflation spiral. The last few decades, however, tell us that corporate management will opt for the easy answer and pass it on.
The Fed has some really difficult decisions to make and I think they will not be raising rates aggressively in 2022. That means the yield curve will steepen and inflation breakevens will continue to increase. It may be time to buy another ticket and ride the “Dead Man Curve” up the hill.
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