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BEs dip then bounce as buyers emerge
Members of the House put their Big Boy Pants on today and actually passed the debt-limit deal that now goes to the Senate. Meanwhile, today had a double-dose of surprisingly weak price data (i.e. unit labor cost 4.2% versus 6% Bloomberg consensus, ISM prices paid 44.2 versus 52.3 Bloomberg consensus).
And the combination of these events set the stage for today’s advance in the major domestic equity indices (Dow +0.47%, S&P +0.99%, Nasdaq +1.28%) and another 3-7bps bull-steepening rally in nominals. However, outside of an initial stumble in the early trade, USD inflation managed to make up the lost ground to end within spitting distance of nominals as TIPS breakevens ended mixed but little changed (~ +/- 1bps).
“The stark month-end weakness across the breakeven curve continued to start the day but buyers showed up at the lows and the rebound in energy helped spur the bounce to a more traditional beta performance by days end,” one dealer explained. “Flows reflected the price action with fast-money sellers continuing to be prominent participants in 10y and 30y while real-money has been better buyers of both real yields and breakevens in spots, with more consistent interest in shorter-dated maturities,” he continued.
Flow-wise in derivatives-space, inflation swap trades on the SDR today included 1y ZC swaps at 229bps, 2y ZC swaps at 226.5bps, 5y ZC swaps at 236.5bps and 235bps, 10y ZC swaps at 245bps, 2469.125bps and 247.5bps (for all of today’s trades, see Total Derivatives SDR, which now also includes information on broker/platform).
Elsewhere, in today's Fed-speak, Philly Fed President Harker was busy again on the pulpit, reiterating that “we should at least skip this meeting in terms of an increase” and added “we are close to the point where we can hold rates in place and let monetary policy do its work to bring down inflation to the target in a timely manner.” Futures currently are pricing a 77% probability of a pause after the skip remarks began yesterday.
Looking ahead, tomorrow bring the May employment report which strategist at Barclays expect a headline print of +200k (versus +195k Bloomberg consensus). As for the well-eyed average hourly earnings, Barclays posits the following:
- ”…We expect average hourly earnings (AHE) to decelerate from the pace seen in April (+0.5% m/m), rising 0.3% m/m (4.4% y/y) in May. However, we think that rates of change in average hourly earnings are being distorted downward by composition effects, with more reliable indicators — such as the Atlanta Fed Wage tracker — showing signs that wages have begun to decelerate noticeably.”
Heading into the final hour of trade, the 2y breakeven is going out at 205.5bps (-0.125bps), 5y at 2011.5bps (+1.5bps), 10y at 217.625bps (unch) and 30y at 222.75bps (-0.75bps).
NatWest: Inflation persistence, revisited
Last week, Ben Bernanke and Olivier Blanchard published a paper looking at What Caused the U.S. Pandemic-Era Inflation (see here), which strategists at NatWest found “insightful”. The bank has used the analysis as a springboard to answer some pressing questions that its clients have pose to it along the lined of “what if the Fed reverses course now and inflation resurfaces like in the 70s” and “what if inflation falls to ~3.5% and stops decelerating”. NatWest answers this below:
- ”… The answer to the former question is more straightforward, in our view. The 1970s saw two massive oil shocks (OPEC 1 in 1973 and OPEC 2 in 1979), which we view as the main cause of inflation then. Additionally, the a very different backdrop makes apples-to-apples comparisons to the same period hard: wages caught up to inflation much easier given the larger share of manufacturing (see BIS discussion on the topic here), differences in how inflation was measured inflation (e.g., mortgage rates being used as input into calculating housing inflation, which creates a feedback loop between Fed hikes and CPI), and inflation expectations were not anchored like now (which admittedly we should not take for a given).
“…Bernanke and Blanchard’s paper in a way addresses the latter of those questions and we will summarize some of the relevant highlights (crudely). They find that tightness in labor markets only made a modest contribution to inflation early on and instead most of the early inflation came from relative dislocations in the goods market, supply chain shortages, and spikes in commodity prices. As the pandemic progressed, the relative importance of the tightness in the labor market to inflation did increases in their models.
“…The authors focus on the vacancies-to-unemployment ratio (v/u), as opposed to outright unemployment rate as they find it has stronger explanatory power. Of course, this isn’t a unique approach by any means - the Fed also pays a lot of attention to the so-called Beveridge curve (relationship between job vacancy and unemployment rate) and Chair Powell himself has referenced the ratio many times in his press conferences and speeches. Their conclusion is that the v/u ratio should fall below its natural rate of 1.2 to bring down inflation. However, the unemployment rate associated with that ratio would depend on whether the dislocations and inefficiencies in the job markets return to pre-pandemic levels (i.e., the upward shift in the Beveridge curve reverses). If inefficiencies are improved (to 2019 levels), unemployment can remain at 3.6 as the ratio falls, but in the extreme case where the Beveridge curve remains where it was earlier this year, then the implied rate of unemployment is 4.3%.
“…What does all of that mean for us? First, there is a path (although an unlikely one) where unemployment doesn’t have increase that much for inflation to return to target. Second, historically 4.3% isn’t a very high level and is well below what we think many investors see as the unemployment threshold the Fed needs before pivoting. Finally, as a team we see many headwinds to the economy, which would push unemployment higher and certainly consistent with levels mentioned by Bernanke and Blanchard. In our view, all of that could be enough for the Fed to pivot by the end of this year, but also allow for inflation to continue drifting back to target rather than stay at an arbitrarily high range like 3.5%.”