There is a general understanding of what happened last week.
The 2.9% rise in average hourly earnings in the US reported, the fastest since
2009 spurred fears of rising inflation. The jump in US interest rates
triggered equity sales and a spike in volatility, which in turn spurred the
unwinding of low vol bets that had been paying off handsomely.
While this consensus narrative has much to recommend itself, there is a
major discrepancy. The rise in US interest rates since both the end
last year and since the January employment data appear to reflect mostly an
increase in real rates and not the inflation premium.
This preliminary assessment is borne out by reviewing the change in
nominal yields and the change in market-based measures of inflation
expectations. The US nominal 10-year yield finished at 2.79% the day
before the latest employment data were released. The yield finished last
year a little above 2.40%. The high yield print has been almost 2.90%--a
50 bp increase from the end of last year and a 11 bp since before the
There are two readily available market-based measures of inflation expectations.
There is the 10-year breakeven, which is the difference between the 10-year
conventional yield and the 10-year inflation protected security (TIPS).
The 10-year breakeven was at 1.98% at the end of last year and 2.12% before
jobs report. It reached 2.14% last week, and is now near
Another market-based measure of inflation expectations is the five-year
five-year forward breakeven, which is similar to the 10-year breakeven, but
uses a five-year forward rate of the conventional and inflation-linked
securities. A similar picture arises. The five-year five-year
forward was at 1.99% at the end of 2017. It was at 2.22% before the jobs
data and now is near 2.21%.
Most of the rise in nominal yields took place before the average hourly earnings
surged. However, the increase in these two market-based measures of
inflation expectations do not explain the bulk of the increase. Both
measures of inflation expectations are now actually unchanged or lower than
prevailed the day before the data were reported while nominal yields are
There are other reasons to doubt that inflation expectations became
unanchored by the average hourly earnings data. First, nearly as soon as
the data came out and economists had time to look at the details, it appeared
to be exaggerated. The increase may reflect the increase pay for
supervisory workers, for example. Second, the increase was in line with the Q3
average (0.3% a month) after a soft (0.2%) average in Q4. Third, other
measures of labor costs, like the employment cost index, did not bear out the
acceleration. Fourth, and importantly, the relationship between average
hourly earnings and the core PCE, which the Fed targets, is weak at best,
which, in part, speaks to the frustration policymakers are experiencing over
the Philips Curve that links unemployment and inflation.
The US reports January CPI on Wednesday. The consensus
narrative says that the CPI is the key report this week, but if our analysis is
right and it has been an increase in real rates rather than the inflation
premium, but 10year yield may not ease as much as one might expect if the
headline and core rates slip economists expect. The Bloomberg survey
found a median forecast for the headline pace to ease to 1.9% from 2.1% and the
core rate to slip to 1.7% from 1.8%.
Another way to gauge inflation expectations is simply to ask
people. The market-based measures may be compromised by liquidity
premium, for example. Surveys have their own methodological challenges to
be sure, like the channel (internet, landline, mobile) and gender bias (women
reportedly typically see more inflation than men when controlled for income and
education). The University of Michigan reports its preliminary February
figures at the end of the week. In January 5-10-year inflation
expectation measure ticked up to 2.5% matching the highest level since August
2017. It is also the average for 2017 and 2016.
The Federal Reserve conducts a quarterly survey of professional
forecasters. The results of the Q1 survey were reported last
week. Essentially, the professionals revised up Q1 18 forecasts but left
the long-term forecasts largely unchanged. Specifically, the Q1 headline
CPI a revised to 2.7% from 2.1%, but this largely reflects the past increase in
oil prices. The expectation for the core rate was tweaked to 2.2% from
2.0%, and the core PCE deflator expectation was increased to 1.8% from
1.7%. At the end of the year, headline CPI is expected to be a 2.2%
instead of 2.1%, while the core PCE deflator expectation was not changed from
Rather than inflation expectations being the critical driver lifting
nominal rates, we suggest an alternative hypothesis, which we think matches the
facts better. The increase in nominal rates reflects a small increase
of inflation expectations but a more significant rise in real rates. Real
rates are rising in the face of changing supply and demand
considerations. Specifically, one of the largest buyers of US Treasuries,
the Federal Reserve has pre-announced it will buy $420 bln less than in
2017. At the same time, the combination of the tax cuts (loss of revenue)
and spending increases ($300 bln over the next two years) means that issuance
is going to rise sharply.
Even for those who advocate fiscal support during economic downturns,
like in 2008-2009, and who rarely see deficit reduction as a key policy goal,
there is a strong distaste for purposely running 4%-5% deficit when the economy
is growing above trend. The proverbial chickens come to roost, in
such a scenario, with the end of the business cycle. The deficit will
swell more during slower economic growth and the base is already high.
Higher interest rates may be necessary to attract global savings at a moment in
time where the economy may not justify higher rates.
In some corners, there are already concerns about the re-emergence of
America's twin deficits. The fiscal deficit gooses the economy, which
has a high propensity to consume imports. The non-energy trade deficit is
deteriorating, and the current account deficit is set to widen. We note,
however, the corporate repatriation of earnings kept offshore, induced by the
tax changes, may show up in the investment income line item of the current
account. This would give the appearance of reducing the current account
deficit--for a short period of time.
We suspect that with the ECB and BOJ still buying all the new net
issuance by their respective governments, and the US the only net provided of
net new core paper, the demand for US Treasuries may hold up well this
year. That is to say that if 50 bp increase in the 10-year yield in
the first six weeks of 2018 means the bulk of the near-term move is likely
already in place. Price pressures may become more evident in Q2, when last
year's anomalies drop out of the year-over-year comparison.