It was a broadly positive week for the equity markets. Domestic stocks were up +2.0% to +2.5% while the overseas markets lagged modestly. For all the uncertainty about trade policy and geopolitics, the markets have been buoyed by robust earnings reports and a raft of share buyback announcements.
This week’s tamer than expected inflation report calmed the bond market, at least temporarily. Both 2-year and 10-year yields drifted higher and most bond categories were relatively unchanged on the week. High-yield stands out with a +0.3% advance for the week.
Wage Growth Likely to Accelerate – Will Inflation Follow?
Last Friday the payroll’s report came out and the unemployment rate fell to 3.9%, a 17-year low.
This week’s unemployment claims number hit a 48-year low. That’s impressive!!
We also crossed an interesting milestone in employment history. The latest JOLTS survey shows that there are now more job openings than unemployed workers. This is the first time this has happened in the 17-year history of the survey.
Theory suggests that as it becomes harder to find workers, wages should be bid up. The chart from Alpine Macro below shows this very correlation. The blue line is the unemployment rate and the red line is average hourly earnings (inverted). Clearly, as the unemployment rate falls wage growth picks up (red line falling means wages are growing faster)
So there is every reason to think wage growth will pick up in the months to come, but so far we haven’t seen much of a response. Friday’s payroll report showed wages growing +2.6%, within the range of the last few quarters.
It seems like a decent bet, though, that this line will trend up and towards the right in the next few months. The $64 million question is whether faster wage growth, if and when it materializes, translates into broader inflationary pressures. History paints a mixed picture on this question. As you can see below, before 2000 inflation tracked the unemployment rate closely. However, post 2000, any correlation broke down.
Why is this? There are a number of theories such as; the decline of unionization, China entering the global trading system (they joined the World Trade Organization in 2001), the technological revolution, etc.
So will inflation break above the Fed’s 2% target in the months to come? The last core PCE report came in at +1.9%, as you can see below.
The Fed is Betting It Will
The Fed, for one, thinks it will. They gave us every indication at their May 2nd meeting that they plan to hike in June and then again in September. A growing group of firms such as Goldman Sachs and JP Morgan see another hike in December as well. As you can see below, the odds of three more hikes in 2018 has gone up materially the last few weeks (blue line).
What this means is that yield is getting much easier to come by. It is been years since money markets have paid much. But with the recent move in the Fed Funds rate to between 1.50% to 1.75%, money market accounts are now actually paying something, as you can see below.
We also crossed an interesting milestone a few weeks ago. For the first time since 2008, 2-year bond yields are now higher than the dividend yield on the S&P 500 (chart below).
This doesn’t mean you should rush out and sell stocks and buy 2-year bonds of course. Only that short-term bond yields are becoming more of a competing asset class for some investor’s money.
And if we do see three more Fed hikes this year, the Fed Funds rate on 12/31/18 will be between 2.25% and 2.50%. This means money market yields over 2% and 2-year bond yields over 3%. We shouldn’t be surprised to see more cash flowing into these options. Now whether it comes out of bonds or stocks will be interesting to watch.
Have a good weekend.
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