The financial media was stunned by the muted response of the bond market to last Thursday’s better-than-expected jobs data. With a print of 288,000 jobs, one might have expected the yield of the 10-year Treasury note to run somewhat higher. However, long-term interest rates are very much the province of inflation pressures. Without upward wage pressures, it is difficult to get sustained upward price pressures, outside inelastic sectors of the economy. In the absence of upward wage pressures, higher prices in inelastic sectors of the economy could lead to disinflation or deflation in sectors with more elastic demand curves. Although the yield of the 10-year note shot up to about 2.69% immediately following the release of the data, the bond market did not like data which indicated poor wage growth and a bias toward part-time jobs. As a result the 10-year note yield fell back to the low 2.60%-area.
To see a list of high yielding CDs go here.
The debate which is raging among economists, strategists and pundits is: How much slack is there in the labor market? A large amount of slack could indicate that wage pressures could remain subdued for an extended period of time. Little slack in the labor market could indicate that wage increases are imminent. We see the situation as follows:
Both sides of the argument are essentially correct, and incorrect. If one judged labor slack within the U.S. borders and assumed that technology (capital spending) will continue to go hand-in-hand with job creation, then labor slack might be fairly small. However, the bond market has a different outlook, as do we. We believe that although there is less domestic slack (especially when one considers that many people who have left the labor force may not ever return), when labor is viewed globally and one concedes that technology can now replace humans in the area of production (rather than merely increasing worker productivity) there could be enough labor slack to keep wage growth modest for an extended period of time, perhaps years (or longer).
There are reasons for the surge in part-time employment. Healthcare regulations play a part, but global and technological competition for jobs also play a parts. The most important factor is that Americans have become accustomed to part-time work and more austere lifestyles. They are willing to accept part-time work and shorter work weeks. The result is more family time and less stress. This new consumer paradigm could result in the much-discussed “new normal” economic conditions.
We agree with optimistic pundits who opine that the economy is much closer to being healed than the Fed believes. However, we believe that a “fully healed” economy probably looks only modestly to moderately better than today’s economy. In other words, whereas the economy was stuck in second gear heading into 2013, it might be at the top of fourth gear today. Fifth gear might result in only a moderate increase to the pace of growth. As we have said many times in the past: “The economy you see might be the economy you get.”
If this proves accurate, long-term interest rates might only rise moderately from today’s levels, neither in a straight line nor especially quickly. The area of the yield curve which could see the sharpest increase in rates is the short end.
Here Come Old Flat Curve?
Pundits and investors were shocked that long-term rates did not respond to last week’s jobs data, but short-term rates have ground steadily higher. We do not understand why people were surprised. Stronger economic data should (eventually) result in tighter Fed policy. Higher short-term rates are considered disinflationary. Disinflation tends to hold down or moderate the rise of long-term rates. This is why we get flatter curves late in economic cycles. Although the first Fed Funds Rate hike is unlikely before mid-2015, the bond market will attempt to get ahead of the situation. Flatter yield curves usually equate to less lending and a risk-off mentality. Higher short-term rates can also result in an increase in corporate defaults.
Defenders of risk assets state that, even if rates rise a bit, they would still be historically low. Although this is true, we believe that the direction of rates means more than absolute rates. Few could argue that growth would benefit from a decline in rates from 8.00% to 6.00%. If that is true, then raising the Fed Funds Rate from effectively 0.00% to 2.00% should create headwinds for growth. Since economic growth is not exactly gangbusters at the present time, a 2.00% Fed Funds rates could shave GDP growth. How much growth could be shaved? We are not economists, but we would not be surprised if a potential 3.5% economy (at time of the first Fed Funds Rate hike) could be shaved to 2.5% to 3.0% with a 2.00% Fed Funds Rate and become essentially flat with a 3.0% Fed Funds Rate. We hope you have been enjoying this economic expansion as it might be in the eighth inning.