Greek Debt Deferral Deal Boosts Risk-On Mood

Jun 22, 2018

The overnight news that Greece (remember that crisis?), has successfully negotiated another can-kicking (read: maturity extensions of debt and interest payment deferrals on said debt) with its EU overlords and that has lent a bit of a risk-on bid to equity markets, and has Treasuries under a spot of bother.  To be sure, on a slow summer Friday (yeah!) the moves aren’t much to write home about, but if anything we’re impressed with the limited range of the 10-year Treasury this month. After a brief foray  to 3.00% on June 13th, the yield has varied between 2.86% and 2.96%. And with the EU adding a 25% tariff on $3.3 billion in U.S. products today (including Senate Majority Leader McConnell’s Kentucky bourbon and House Speaker Ryan’s home state Harley-Davidson motorcycles), the coming trade war news is only likely to increase. That will aid bids in longer-term Treasuries as a bit more sand is thrown in the gears of international trade. As we close out the week, the 10-year note is off 5/32nds in price to yield 2.92%.

 

  Economic News

 

The enthusiasm for the economy that Fed Chair Jerome Powell displayed at the FOMC press conference last week was still on display on Wednesday in a Portugal speech. He mentioned that the Fed will keep raising short-term interest rates at a gradual pace. He backed away, however, from expecting to hike at a faster pace, mentioning that despite the unemployment rate at an 18-year low of 3.8%, and inflation near the Fed’s 2% target, the case for continued, gradual increases “is strong.”  He stated that the case for a faster pace of tightening out of concern that the low unemployment rate will lead to accelerated inflation couldn’t be made to his satisfaction. He noted that the sharp drop in unemployment since the Great Recession ended in 2009 has occurred “without much apparent reaction from inflation.”

 

That touches on one of the ongoing conundrums to this economic expansion which is the lack of year-over-year wage growth versus levels seen prior to the crisis. The latest annual average hourly earnings gains have been in the 2.6% -2.8% range and that continues to trail the 3.5% -4.0% pre-crises range, not to mention even higher levels in the 90’s and before. 

 

Given Powell’s somewhat sanguine comments on the unemployment rate it’s interesting to note that in the latest Summary of Economic Projections (SEP) the Fed, while expecting unemployment to bottom at 3.5% in 2019/20, kept the longer-run unemployment rate at 4.5%. Think of the longer-run rate as the level the Fed thinks represents an equilibrium point for the economy.  An unemployment rate that reflects a labor market not too hot, not too cold. If Powell is unconcerned about the low unemployment rate it seems they would have adjusted the longer-run rate down in the latest SEP and not kept the gap between the two at nearly 1%.  

 

To be fair, the equilibrium, or longer-run, rate is an unobservable variable so it’s subject to some uncertainty, but it seems clear at this point it’s something less than 4.5%.  And given the demographic forces at play in our economy the rate could be considerably under 4.5%. The point in this belabored discussion of unemployment rates is that when looking at the Fed and their planned rate hikes, in order to avoid an inverted yield curve, and the recessionary implications that entails, some upward pressure on long-term rates will be necessary.

 

One of the primary catalysts of inflation, and hence upward pressure on long-term rates, is accelerating wage gains and the cost-push/demand-pull inflation that would engender, especially with the consumption-based nature of the U.S. economy. Without that  pull of higher wage gains, the economy loses one of its catalysts for higher long-term rates. 

 

Without that wage-related impulse to nudge long-term rates higher, we may be closer to a flat-to-inverted curve than many may realize. With the 2yr-10yr yield spread at just 35bps, a 25bps rate hike in September and December would certainly seem to be more than enough to invert the curve given a range-bound long-end. Given the nearly 100% predictive rate that an inverted curve signals a looming recession, the Fed will be very reluctant to force such a move. In fact, several Fed officials have been on record as not wanting to hike short-rates and forcing an inverted curve. So keep an eye on wage gains in the monthly jobs numbers as a  tell on whether long-term rates will get an inflation push higher. And as an aside, keep an eye on the Fed speak between now and the September FOMC meeting to see if there is a developing consensus to adjust lower their longer-run unemployment rate forecast and ease some the drive to hike rates on a quarterly schedule. 

Finally,  consider that while the Fed has been resistant to lower their long-run estimate of unemployment it may be instructive to consider the Japanese case. They have had an aging demographic and shrinking population for years, and with their restrictive immigration policies the labor force has been under downward pressure for years. This has contributed to a very low level of unemployment but one that hasn’t led to any great increase in inflation or wage gains. Could the Fed, because they have been reluctant to consider the equilibrium unemployment rate is perhaps lower than currently estimated, be tightening too much given there is still material slack in the labor market? 

 

 

Market Update  Are We Headed Towards Japan-Like-Unemployment?

 

With the above discussion of the most-likely rate of longer-run unemployment, it’s helpful to look at the Japanese case. The graph tracks the unemployment rate for both economies going back to 2006. As shown. Japan’s rate has trended considerably lower with the current rate at 2.5% versus 3.8% in the U.S. The Japanese economy, even with the low unemployment rate, is not experiencing high wage gains or inflation. An aging demographic and shrinking population are contributing to a low, non-inflationary rate of unemployment. Could our economy be slowly headed in that direction? And if so, could the Fed be tightening too much when there is still material labor slack still remaining?

 

Unemployment Rate

 

 

Agency Indications  Market Rates

 

Market Rates

 

 

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