Macro & FICC Research Published: 2021 05 14 06 51
SEB FI & FX Strategy
Messy transition creates a difficult balancing act for the Fed
Summary:
In market focus. Inflation; Labour market; Tapering.
Global macro and risk appetite. The weak US jobs report tamed tapering fears and boosted the risk appetite while a massive upside surprise in April inflation worked into an opposite direction. Reopening, generous liquidity conditions, earnings upgrades and extremely low real yields are fundamentally supportive for the risk sentiment but uncertainty on inflation is rising.
Inflation: Increasing risks for a more broad upturn in inflation expectations. The April US inflation shock highlights upside risks to near term inflation. We have raised our inflation forecast over the next 12 18 months substantially, expecting CPI to approach 5% y/y in the coming months and core CPI to remain above 3.5% y/y for the most of H2 2021. Our main scenario continues to be that the upturn in inflation will be temporary, but risks have increased for a more broad-based upturn in inflation expectations which could affect wage setting also in the medium term.
USD rates: Rising inflation expectations pushing nominal yields higher. Fed funds futures pushed down the likelihood for a Fed hike in 2022 to around 50% after the weak labour market report before taking it back to around 65% after the inflation figures. A change to the Fed’s rhetoric at the June meeting seems unlikely despite high inflation, supporting our view of a range-bound Treasury market in Q2. Rising inflation expectations are likely to bring the upper end of our 1.60 1.80% trading range for the 10y Treasury yield into the focus. Tapering signals may come in July or at the Jackson Hole conference in August, which we expect will push long rates higher with the end 2021 target of 2.00% for the 10y Treasury yield intact. We maintain our bearish positions in long US rates.
FX: Between a rock and a hard place. Surprisingly high inflation print in the US is shaking markets. Inflation without a central bank action is not currency positive but should expectations move towards the Fed preemptively stemming rising inflation expectations then we are on a path towards a stronger USD. For now we may have some more days of adverse risk appetite working for a stronger dollar but as long as the Fed is not guiding markets to a policy shift, we continue targeting EUR/USD at 1.24 by mid 2021. EUR/SEK should now continue trading in a range but we think ultimately the support around 10.10 will give way opening up for a serious test below 10.00.
ECB April meeting account: Not a word about tapering. The market has been speculating for some time that the ECB would start reducing the PEPP purchases in June. Many probably expected that the Governing Council (GC) discussed the outlook for purchases already in April, but President Lagarde told at the press conference that the tapering discussion is premature and it was not discussed. The ECB probably wants to see the service sector opening and tourism to pick-up before it can be confident enough to indicate an exit from the current policy stance. This will still take some time. We look for clues at today’s April meeting account on how committed the GC is to keep a lid on long rates and if there was any discussion on the possibility of altering the PEPP parameters.
Forecasts. No changes. Find comprehensive forecasts here.
Trade highlights:
- Update: Swaption seagull in USD 10y IRS. We expect long rates to move higher within a range. Entered at zero cost on 16 Apr. Current P/L: 445k / 100m notional per leg. Monitor closely, prepare to take profits if the market turns.
- Update: Pay EUR 2y15 vs. 2y2y. Entered at 54.4bps on 22 Jan; Currently 81.6bps; Initial target of 85bps but more upside seems increasingly likely.
Double challenge for the Fed: Disappointing labour market and high inflation
Digesting implications of last Friday’s disappointing US labour market report was the key focus for markets until the April inflation report showed a massive upside surprise on Wednesday. The implied probability for a Fed rate hike by end 2022 priced by the fed fund futures moved accordingly, first from around 65% to 50%
after the labour market report and thereafter back to just below 70% following the inflation report. Based on a rapid increase in inflation over the coming months, we have been arguing that the market is likely to price an around 70 90% probability for a 2022 rate hike in the coming months and we still regard this as a reasonable expectation. Some modest increase in short-rate expectations from their current levels seems possible in a run-up to the Fed tapering, which is in line with our view of nominal yields increasing slightly within our expected trading range before breaking decisively higher.
Fed funds Jan23 implied rate
It will likely take a few more months to conclude whether inflation pressures amid the reopening and supply side constraints are indeed transitory or of a more persistent nature. In the short-term, the Fed will continue playing down high inflation, which it has been also warning about. However, the longer the price pressures persist the larger the challenge for the Fed considering that it has clearly communicated that it wants to see substantial progress towards policy goals of full employment and inflation target before tapering the bond purchases.
In this edition of SEB FI & FX Strategy, we have another closer look at the US labour market and inflation, ad discuss their implications for the Fed policy and markets.
Rising inflation expectations driving nominal yields – real yields to remain depressed
As discussed in “Bond markets taking a breather ahead of Fed tapering”, 16 April, we foresee a range-bound market in the US long rates while waiting for new signals from the Fed. In terms of the 10y Treasury yield, we expect it trade mostly in the 1.60 1.80% range until the Fed begins to signal tapering, and to increase to 2.00% by the end of the year. We maintain this forecast unchanged. We also continue to think that there is a limit how much long yields, especially real yields, can increase before triggering an adverse reaction in stock markets. As we have argued before, a too rapid rise in real yields would likely bring risk sentiment under pressure and trigger safe-haven buying in bonds pushing yields lower again. Nominal yields can, of course, rise with real yields remaining unchanged or even declining as long as the rise in nominal yields is driven by rising inflation expectations. Upside surprises to inflation have potential to push inflation expectations even higher, thus lifting nominal yields without a corresponding rise in real yields.
10y Treasury yields
Market-based inflation expectations in the US have remained on an uptrend with the 10y BEI reaching 2.55%. The US 10y real yield has been in a roller-coaster with the major part of the sharp increase from
1.10% January to just above 0.60% erased over the past six weeks as the real yield has declined again to around 0.90%. Stock markets have been boosted the renewed declined in real yields, upbeat PMIs, reopening expectations, generous liquidity conditions, the record strong earnings season.
US: Market based inflation expectations
As regards market inflation expectations, the US 10y BEI has reached and breached our mid 2021 target of 2.40% established in the beginning of this year. With sharply increasing spot inflation and with inflation risks in focus, we expect further upside in BEIs in the coming 2 3 months. While the recent increase has taken the 10y BEI the highest level since 2013, at around 2.55% it still implies that markets are not yet completely pricing a long-term fulfillment of the Fed’s inflation target. This is because the BEI does not separate true underlying inflation expectations from the inflation risk premium that, for example, the Cleveland Fed’s model estimates at around 0.50%. Also, the Fed’s preferred inflation measure PCE is an average a few tents of a per cent below CPI. On this basis it can be argued that it would take at least another 0.2%-points increase in the 10y BEI to around 2.75% to fully price an average long-term inflation in line with the Fed’s 2% inflation target. This implies that long nominal yields can indeed continue rising somewhat with real yields remaining at current levels, which should be supportive for the risk sentiment and negative for the dollar.
FX between a rock and a hard place
The elevated and frankly troublesome US CPI figures on Wednesday added to the already somewhat confusing near-term picture for the currency markets. Although most of this elevated price pressure is expected to be transitory, the Fed comments immediately after the release also revealed a central bank caught by surprise. Details reveal that much of the price increases came from surging prices on used cars and other parts of the economy affected by the reopening after a successful Covid 19 vaccination. FX normally trades well correlated to central bank expectations and in this respect the market should pay close attention to what is happening to inflation expectations. The labour market remains soft and in a state of abundant
resources, but the labour market is also expected to normalise quite fast. If this remains the case despite the poor payrolls number for April where new jobs disappointed massively, and in the context of rising inflation expectations the market will look to Fed for guidance and hence the comments near-term will be crucial to watch. Inflation without central bank action is not currency positive but should expectations move towards the Fed having to be pre-emptive to stem rising inflation expectations then we are on a path towards a stronger USD. This scenario will also be negative for risk appetite as equity markets. For now we may have some more days of adverse risk appetite working to strengthen the USD but as long as the Fed is not guiding markets to towards a policy shift, we remain with our view of a weaker USD with EUR/USD targeting 1.24 by mid 2021. As long as the uncertainties remain the risk is that a longer (strong) USD correction happens with weak risk appetite driving the currency higher. Most currencies will weaken vs. the USD in this scenario.
When it comes to SEK we note that the dividend season is over and more normal drivers are expected to take over. Whilst Swedish inflation also surprised on the upside, the case is relatively clear that we have already seen the peak in CPIF and that the Riksbank will face a clear headwind to reach the inflation target later this year. But with inflation being such a hot topic there is little that supports the view that the Riksbank will move to adopt an easing bias anytime soon, hence interest rate developments will continue to be driven by international/US developments. In the near-term the currency is stuck trading closely with the risk appetite, but we continue to make the case for more defensive characteristics making the krona less vulnerable in times of equity markets decline. EUR/SEK should now continue to trade in a range but we think ultimately the support around 10.10 will give way opening up for a serious test below 10.00. We will soon receive the portfolio flow data for Q1 2021 and most likely it will show another relatively large outflow as regards equities where Swedish investors continue to invest in foreign markets producing a SEK outflow.
Messy transition creates difficult balancing act for the Fed
The weak April jobs report, with only 266k new jobs instead of the expected around 1 million, has further complicated the picture for the Fed. We continue to stick with our forecast for a September tapering decision but admit that risks for a slightly later start to actual tapering – in December rather than October - has increased. Sharply higher price increases in April (more below) raises the pressure on the Fed but will not affect policy in the near-term as the Fed has consistently warned about short-term upside risks from disturbances during the reopening.
Lack of labour supply rather than demand held back hiring in April. The implications of the weak jobs report on Fed policy are not straightforward. There are many reasons to believe that lack of labour, rather than too little demand, held back hiring in April and that this spilled over into wages too as employers had to pay more to lure back workers. In April nearly 45% of the companies in the NFIB small business survey reported labour shortages, the highest number since the series began in the mid 70’s.
US: Labor shortages despite high unemployment (shaded areas denote recessions)
The JOLTS report, which shows flows in the US labour market, showed record-high job openings already in March. Anecdotal evidence in the Beige Book and comments in business surveys also suggest that hiring has become more difficult.
US: Labour openings (shaded areas denote NBER recessions)
Faster earnings growth. Average hourly earnings data in the employment report have not been a good indicator for wage developments in the US for the past year, since they are not adjusted for changes in the mix of workers. However, it is noteworthy that earnings increased by 0.7% m/m in April vs. the expected 0.1%, at the same time as the largest increases in employment were noted for leisure and hospitality. These are usually lower paid jobs, which should have worked in the other direction.
Lots of slack left. On the other hand, it is also hard to see that the US labour market should be reaching its limits already at a point when over 8 million jobs are still missing from before the pandemic. Our view, which seems to be shared by the Fed, is that temporary factors, tied to the pandemic, continue to hold back the supply of labour, such as closed schools/day care, making parents stay at home, fears of the virus and generous unemployment benefits.
US: Employment still a long way from pre-pandemic levels
The current level of extra federal unemployment benefits means that around half of unemployed workers are according to some estimates making more money staying at home than going to work. The extra benefits will end in August and we expect workers to start returning in advance of this. Several republican states, though representing a limited share of the total number of unemployed, have already decided to cut back the support or replace it with a return-to-work bonus. Moreover, the Biden administration this week issued directives that unemployed turning down job offers without necessary cause (such as lack of child care due to school closures or legitimate concerns over the virus) would lose their benefits.
The fast progress in vaccinations should help solve the other problems even if the transition back to for instance on-site learning has been complicated in several areas. Workers that are not currently unemployed have already started to return to the labour market, which was reflected in a small increase in the labour participation rate from 61.5% to 61.7%, something that contributed to the unexpected increase in the unemployment rate to 6.1%. We expect that development to intensify in the coming months.
Still, the hurdles in April suggests that it may take a bit longer before the recovery on the labour market gains speed, which is a downside risk also for the coming months.
Turbulent transition from pandemic to more normal economy. The pandemic is probably affecting the demand side of the labour market too. One of the sectors that saw the largest job losses in April were couriers and messengers ( 77k), a category that is likely to have been supported during the pandemic. Auto manufacturers shed 27k jobs in April, which is likely to have been driven by lack of semiconductors which has led to a temporary closure of some production.
Furthermore, problems with seasonal adjustment may have contributed to the weak April report. April is usually a strong month for hiring but seasonal effects are right now likely overshadowed by the trends connected with reopening from the pandemic. Non-seasonally adjusted employment change was up by 1.1 million, a somewhat slower pace than during the previous two months at around 1.2 million, no acceleration but not a large setback either.
US: Non-farm payrolls seasonally and non-seasonally adjusted (monthly change)
Delicate balancing act for the Fed. For the Fed, the weak jobs report will not be interpreted as a sign of a weak economy. But it is not signalling persistent overheating either, as shown by the recent flurry of Fed comments after the report. The Fed has been very focused on measures of job participation, to the extent that is members habitually add the decline in labour force participation to the actual unemployment numbers in order to reach a “true” unemployment measure. This suggests that the Fed is confident that most workers will return after the pandemic and that in the view of the Fed there is still a lot of slack on labour markets.
Uncertain pace of recovery ahead. Even if the current mismatch between demand and supply for labour is temporary there are also large uncertainties ahead when it comes to the strength of the recovery going forward. The strength in demand in the beginning of the year reflects the strong fiscal support in March (the USD 1.9tn Corona Rescue bill) and the disbursements of household impact payments of in total USD 2,000 in January and March for every eligible individual. The pattern around the impact payments from 2020, and during earlier instances such as the Bush payments, suggest that households spent a large chunk, or around 1 3, directly but used the remainder for savings or paying back debt. If so, the pace of spending on goods can be expected to decline in the coming months. We expect this to be offset by increased spending on services instead, which should support hiring as job losses have been largely concentrated to the services sector. At the same time there are lower risks of strong overshooting than for goods spending (there is a time constraint on how much restaurants and entertainment you can visit to make up for lost opportunities last year). This may temper the demand later in 2021 and especially in 2022, when the support from fiscal stimulus is reduced. Our forecast is that households will smooth their increased savings over these two years and that personal spending will return to, but not exceed, the earlier trend, but there are large uncertainties on both sides of this forecast. The retail sales report for April, which will be released on Friday May 14 will be a first test on household spending behaviour. We expect a setback for goods spending but offset by increased demand for eating out. In addition, if lack of workers constrains the ability of employers to meet some household demand right now these opportunities may not come back later but instead translate into a temporary increase in prices.
Too early for tapering talk. For the Fed, still large amounts of slack in the labour market and great
uncertainties over consumer behavior going forward means that it is far too soon to send any signals of policy changes. This was also the message from Fed speeches this week (excluding the well-known hawk Dallas Fed Robert Kaplan). The employment-to-population ratio is now above where it was when the Fed decided to start tapering in December 2013 76.9% in April 2021 vs. 76.1% in December 2013), but the Fed has been clear that it will wait longer this time. The Fed will need to see more jobs reports but also more evidence on spending. Still, while the Fed has made full employment a prerequisite for hiking rates, the bar for tapering is lower, where the Fed needs to see a “substantial further progress” towards its goals.
Employment to population and rate hike cycles
Inflation testing Fed’s tolerance. The Fed has consistently downplayed “transitory” increases in inflation and it seems that they are willing to overlook a near-term acceleration in wage increases too, if caused by temporary mismatches during the reopening phase. Still, there is a limit to the Fed’s tolerance and especially if this was accompanied by a further increase in inflation expectations. The 3% y/y increase in core inflation in April touches the upper limit of what some Fed members have said they are willing to accept but the Fed needs to see more months of inflation data too.
The comments from Fed chairman Powell at the April press conference, and from Fed Governor Brainard this week suggest that the Fed now sees inflation expectations as more in line with the Fed’s target while the Fed’s new favoured measure of inflation expectations, the Common Inflation measure, which is based on a mix of survey and market based expectations, has moved back marginally above 2%, for the first time since 2014. On both accounts, inflation expectations are probably still on the low end of what the Fed would like to see.
Fed common inflation expectations measure
We stick to September tapering for now, but July FOMC will be key. We earlier saw a possibility for the Fed to start paving the ground for a tapering of asset purchases already at the 15 16 June meeting. The disappointing April employment report makes this less likely. Instead, such a signal may come at the 27 28
July meeting or in the expected introductory speech by Mr Powell at the annual Jackson Hole Central Bank symposium in August (no date set yet). The latter may be too late of a warning to be considered “well in advance” of a tapering decision already at the 21 22 September meeting, which continues to be our base case. Instead, the decision could be delayed until the November 2 3 meeting. If so, the Fed would start reducing monthly bond purchases in December rather than as earlier expected in October.
We continue to expect bond purchases to be cut back by USD 10bn per month, which means that they would be concluded by September 2022 in our base case or alternatively in November. Thus, we also stick to our forecast that rate hikes will not begin until 2023, to give the Fed time to evaluate the effects of their tapering before tightening policy further. That markets reacted by lowering the anticipated start of rates hike after the April employment report is thus reasonable, even if the report was not as weak as the first impression would suggest.
More reopening inflation in the pipeline
The April inflation shock highlights that the current crisis is like no other and we have to go all the way back to 1981 to find a higher monthly change for US core inflation. A number of large price increases contributed to the high reading with a 10% increase in the price for used cars contributing 0.3pp to the total CPI and as much as 0.35pp to core CPI (ex food and energy). Other large contributors were transportation services 0.2pp (core) and lodging away from home (hotels) 0.1pp. Large price hikes on car rentals, insurance and airline tickets were important contributors to the high transportation costs. We have highlighted that hotel and transportation prices would normalise when restrictions were removed but our forecasts assumed that the recovery would be more gradual lifting inflation by around 0.1 per month during a 4-month period. The price increases in April on hotels and transportation were more in the region of 0.3pp above the historical trend.
US: CPI services
The upturn in prices for used cars is more of a genuine price increase. Prices for used vehicles declined temporarily last spring but quickly recovered. Rumours ahead of the April CPI indicated upside risks for used cars, but we (and most others seems) underestimated the upturn in April.
US: CPI used cars and the Manheim value index
Looking at the coming months the strong April reading highlights upside risks to near term inflation.
Transportation costs are still well below the pre-crisis levels and a continued normalization is very probable.
Also, auction prices for used cars, which normally leads, used cars in CPI indicate that prices could continue to rise sharply in May.
Apart from these probably temporary inflation drivers, other prices were also slightly higher than expected.
After the strong April reading, we have raised our inflation forecast over the next 12 18 months substantially. The main driver is the rising prices of used cars which are expected to continue to rise very rapidly in May. Thereafter the outlook is significantly more uncertain. The large price increases on used cars is said to be driven by purchases of rental firms which have ended up with too small fleets when demand picked up after restrictions were removed. At the same time many households seem to have spent part of the government checks on cars which has added even more fuel to the spiking prices. Possibly prices could partly be reversed further ahead. Still, upward pressure on many industrial goods and some spill-over from rising commodity prices continue to be upside risks to our forecast.
Our main scenario continues to be that the upturn in inflation will be temporary, but a larger upturn in inflation increases the risks for a more broadly based upturn in inflation expectations which could affect wage setting also in the medium term.
US: CPI
Real money value finder
The table below shows yields (YTM) in assorted countries in respective local currency government benchmark bonds and yields from SEK, NOK, DKK, EUR and USD investors’ point of view by accounting for respective currency hedge costs with the aim of providing investors in different domiciles an overview of FX hedged government bond yields. Note that actual relative expected returns over an investment horizon shorter than to maturity will crucially depend on spread movements.
Benchmark bonds: Yield to maturity, local currency and FX hedged
Source: SEB
Summary of macro, fixed income and currency views
Open trade recommendations
Closed trade recommendations in 2020
Systematic currency strategies
Jussi Hiljanen jussi.hiljanen@seb.fi
46850623167
Carl Hammer carl.hammer@seb.se
46703026128
Olle Holmgren olle.holmgren@seb.se
46850623268
Elisabet Kopelman elisabet.kopelman@seb.se
