HIGHLIGHTS OF THE WEEK

  • Another week, another sell-off in the bond market. As of the time of writing the U.S. 10-year yield stood at over 2.8%, up more than 10 basis points from the end of last week.
  • U.S. payrolls expanded by 200k in January while the unemployment rate remained steady at 4.1%. The big story though was the acceleration in wage growth. Average hourly earnings growth hit 2.9% year-on-year, up from 2.6% and the fastest growth since 2009.
  • Recent economic data cement the case for the Federal Reserve to raise interest rates at its next meeting in March. Expect at least another two rate hikes from the Powell-led Fed before the end of 2018.

 

Faster Growth + Inflation = Higher Bond Yields

Another week, another sell-off in the bond market. As of writing the U.S. 10-year yield stood at over 2.8%, up more than 10 basis points from the end of last week. Since the beginning of the year, the yield has risen over 40 basis points and now sits at its highest level since 2014.

The rise in yields is both a real growth and inflation story. On the real side, the sell-off has come as the median Bloomberg forecast for 2018 real GDP moved up 30 basis points to 2.6%, from 2.3% last October. Undoubtedly, tax cuts played a role. The biggest increases came as they were announced and then passed into law.

On the inflation side, market-based measures of inflation expectations have also moved up. The five-year forward inflation rate (an indicator of expectations for inflation five-to-ten years from now) has moved up over 20 basis points since the start of the year (Chart 1). Tax cuts are expected to push economic growth further above its trend rate and also increase the supply of Treasury securities, even as the economy approaches full employment.

Bond market moves have also been supported by economic data. Most relevant, the job market shows little signs of slowing. Job growth in January hit the 200k mark, ahead of the 181k per month averaged over the course of 2017. What’s more, wage growth accelerated noticeably to 2.9% year-on-year, from 2.7% in December (Chart 2). The rise in compensation is evident in other metrics as well. The employment cost index (ECI) rose to 2.7% (from 2.5%) year-on-year in the fourth quarter, while compensation per hour in the productivity and costs (PLC) data jumped to 2.2% (from 0.9%).

The acceleration in wage growth will come as a relief to believers in the Phillips curve, giving credence to the notion that as workers become scarce, the wages offered to attract and retain them should rise. At the same time, recent data have also shown the importance of “shadow slack.” While the unemployment rate has been fairly steady, the employment to population ratio of 25 to 54 year olds has moved higher (it edged down ever so slightly in January to 79.0% from a cycle high of 79.1%). Still, its steady improvement is more consistent with the gradual rise in wage growth than the unemployment rate alone.

The increase in bond yields over the start of 2018 makes sense given these cyclical dynamics. Still, we would caution about extrapolating recent moves much further going forward. While the economic data support an ongoing expansion, the structural forces weighing on interest rates have not changed. Population aging will continue to exert downward pressure on the economy’s trend growth rate and the terminal (or neutral) level of the federal funds fate. At the same time, continued pressure on global bond yields from elevated debt levels and structural impediments to growth will keep a lid on U.S. yields.

All told, economic data and fiscal policy developments cement the case for the Federal Reserve to continue to normalize policy. Still, with a neutral rate in the neighborhood of 2.5%, three hikes in 2018 should be more than sufficient to keep a lid on inflation and allow any remaining labor market slack to be absorbed.

James Marple, Senior Economist

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