• The strength of inflation will be the biggest market surprise in 2018’s second half, forcing the Fed to continue its rate raising regime;
• At the same time, the slowdown in world growth (not helped by the rise of protectionism) may keep the world’s other major central banks in easy money mode, thus feeding U.S. dollar strength and negatively impacting emerging market economies;
• Low rates, worldwide, increase the demand for long-term U.S. Treasury Notes and Bonds, keeping long-term U.S. yields from rising in step with Fed Funds;
• As a result, it appears likely that the yield curve will invert;
• In the year following a yield curve inversion, history shows that economic growth slows, equity returns are low, and in the fixed income markets, spreads to Treasuries widen, especially in the high yield arena.
The issue not being openly discussed but worrying the market is the fact that we are now, and have been, experiencing inflation, but it has not been officially recognized. Fifty years ago, the famous economist, Milton Friedman, explained in simple terms that inflation always occurs when money creation occurs faster than the economy grows. The massive amount of money created in the aftermath of the Great Recession did cause “inflation.” But that inflation occurred mainly in equity and real estate values. We have been conditioned to look only at the prices of consumer goods and services when we think about inflation. In the post-recession era, the rapid pace of technological change, its impact on the prices of consumer goods (the “Amazon” effect), and the changes in attitudes toward sharing vs. owning have kept those prices contained.
Nevertheless, there are significant signs, even in those narrowly defined price indexes, that inflation is emerging. The Producer Price Index (PPI), for example, which generally leads the Consumer Price Index (CPI) by a few months, rose at a 3.4% year over year (YoY) rate in June, up from a 3.1% rate in May. Of interest, the transportation sub-index, a key component of costs, rose a whopping 1.3 percentage points in May (a 15.6% annualized rate) and 7.7% YoY.
It appears that when one of the “watched” indexes shows signs of emerging inflation, the Fed changes the index it keys on to one that is more benign. Today, it is the index of the wages of non-supervisory workers that is getting all of the attention. This is, and always has been, a lagging indicator of inflation, as employers know that wage rates are sticky to the upside and raise the general pay scale only when they have to. Furthermore, this particular index has recently been distorted by shifts in its industry skills and demographic composition. Over the past year, this particular index has grown at a 2.7% annual rate, not showing any acceleration or deceleration on a quarterly basis. By concentrating just on this index, the Fed has concluded that inflation isn’t an issue. One must wonder why the Fed doesn’t look at the reality of rapidly rising gasoline prices, labor shortages in transportation, the skyrocketing cost of construction, or the escalating cost of a mortgage. The Employment Cost Index, for years the darling of the Fed when it came to assessing underlying wage trends, now stands at a cycle high. Yet it is being ignored by Powell and Company.
The point here is that when the lagging indicators show rising inflation, it has, by that time, become “ingrained,” and it then takes longer and requires more tightening (higher rates) than if the Fed had acted earlier. That, of course, makes Fed overreaction more likely. While there is no recession currently in sight, a Fed overreaction in a slow growth economy could just tip those scales. That wouldn’t be a first, as the Fed’s fingerprints have been all over each of the post-WWII recessions.
The Fed relies on econometric modeling in making its forecasts. Those models rely on post-WWII data. If today’s economy acted like the economies of the 60s, 70s, 80s, or 90s, then, those models might be insightful. But, today’s economy is powered by technology, changing attitudes toward consumption, and much different demographic and labor force characteristics than the economy of even 10 years ago. Its reaction function is different. Models with data from bygone eras have little chance of getting it right. And, even looking back, before the economic changes wrought by the Great Recession, the Fed caused ten recessions and there were only three soft landings. That’s because the economy reacts to Fed tightening differently each time (in economic parlance, “the economy reacts to Fed tightening with a long and variable lag.”). So, the few times they did get it right appear to have been pure luck.
We are seeing huge issues in the labor markets with more jobs than job seekers (an historic first), and inability to find skilled workers. Eight times each year, the Fed publishes something called the “Beige Book.” This is a compendium of detailed economic minutia from each of the 12 Federal Reserve Regional Banks. In the latest release, the comments from every region had the same or similar concerns about the labor markets. The following quote from the Dallas region was typical:
Labor market tightness continued across a wide array of industries and skill sets, with several contacts saying difficulty finding workers was constraining growth.
The labor market is so tight that employers are actually “hoarding” their employees. The number of physical layoffs are now at lows not seen since the 60s when the labor force was half of what it is today! If the Fed would simply look beneath the headline data on the pay scale of non-supervisory workers (i..e, the 2.7% wage growth rate), they would see that job switchers are getting an average 3.9% wage increase, and that job switching is accelerating.
There is other evidence, too. The Atlanta Fed’s wage tracker index grew at a 3.9% annual rate in June, up from 2.8% in May. And, the Cleveland Fed’s Median CPI measure, acclaimed by research as the best inflation gauge available, accelerated significantly in June.
All of the above indicates that this year’s second half will be marked by wage acceleration. It doesn’t appear that this is currently anticipated by markets or policymakers. When that occurs, the Fed will have no choice but to continue to raise its Fed Fund rate. Meanwhile, the slowing economies in the rest of the world, especially China, will likely keep other major central banks in easy money mode.
When faced with a 10-Year German Bund yield of 0.40%, or a 10-Year Japanese Government Bond yield of 0.10%, foreign investors see 10-Year Treasury yields of near 3% as a bargain, and their demand will prevent U.S. long-term rates from rising in lock-step with rising Fed Fund rates. Given the inevitable rise in wage inflation and the expected Fed reaction, a yield curve inversion appears to be highly likely.
As I have said in recent writings, even the Fed, itself, believes that a yield curve inversion is the most reliable indicator of an oncoming recession. In the past, whenever there was such an inversion, in the four quarters immediately following, economic growth slowed, returns in equities fell significantly, there was a switch in equity leadership to more defensive sectors, and, in the fixed income market, spreads to Treasuries widened, most notably in High Yield. Maybe, because of the unusual behavior of the world’s central banks this cycle, it won’t play out the same. But, there are bound to be economic and market impacts.
Conclusions
The markets aren’t currently prepared for the surprising strength we are likely to see in inflation gauges for the next few quarters. The Fed will have no choice but to react, and a yield curve inversion appears highly probable. Investors should position portfolios today in anticipation of such events.
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Unconstrained Medium-Term Fixed Income ETF (FFIU).
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.
