It’s all about the US labour market. After three full trading days to evaluate the non-farm payroll data that came out on Friday, it is evident that they have swung opinion on the rates outlook once more. And the critical factor, as earlier in the year, is wage inflation.
The 2.9 per cent year-on-year increase in average hourly earnings for September was the highest rate of increase since 2009.
That is exactly what the White House would like to see, and exactly what the Federal Reserve would prefer not to spot, assuming it does not want to raise rates.
Almost a week later, and even after the announcement of a surprisingly sharp fall in producer price inflation on Wednesday, it is clear that the numbers have driven a significant shift in rate expectations.
The Fed Funds futures market’s judgment is that the odds on two more rises in the Fed Funds rate this year have at last surpassed 80 per cent. This is dramatic.
A year ago, before the corporate tax cut passed Congress and Jay Powell asserted himself at the Fed, the odds on such an outcome were put at zero. It is only in the past two months that four rate hikes has come to be seen as more likely than three. (The performance of US stocks this year is all the more impressive given 2018 opened with the market unconvinced that the Fed would raise rates more than twice. The Fed has broken the news that rates must rise with minimal disruption).
Perhaps more interestingly, sentiment is shifting on the likelihood of more rate increases next year, although investors still appear confident that we will see the tightening cycle tail off by the end of the year.
The same exercise for the implicit probabilities of different interest rates as of the end of December next year shows that the market still does not really seem to believe that the Fed will keep steadily raising rates, but it is at least beginning to come round to the idea.
Assuming two more hikes this year, it is now seen as a fifty-fifty shot that we get at least another two hikes in 2019 — and again this has risen sharply since the wage data last week.
Average hourly earnings have been announced at a 2.9 per cent increase once before this year, in February. That led to a dramatic equity market correction, and the wage number itself was subsequently revised downwards.
So we now have a clear picture of a rates market firmly wed to the notion that wage inflation is central to the Fed’s reaction function.
Meanwhile, 10-year Treasury bond yields have risen to hover below 3 per cent, a level they have breached three times this year.
This is back near the top of the trading range for the year, but is yet to break through; another test of whether the markets have the appetite to take 10-year yields significantly above 3 per cent is in the offing.
We have another test coming up. Viewed in terms of real yields, where long-term yields are compared to bond market inflation break-evens, the market is nudging back towards a significant tightening of financial conditions. But again, it is staying just within recent bounds.
Since 2011 when the debt ceiling crisis, followed by “QE-infinity”, pushed yields sharply lower, there was a sharp rise in real yields in 2013, as the Fed prepared to taper off QE. And for the past five years, real yields have undulated, without ever exceeding 1 per cent. Real yields are now once again just under 0.9 per cent.
Such levels are not restrictive, but a further rise in real yields from here would mark the tightest conditions in the US since the crisis. Not just the Fed’s rates but its policy of selling down its portfolio is pushing upwards on rates.
In this light, the performance of US stocks this year, with the S&P 500 up 8 per cent, is impressive. Financial conditions have tightened and done so faster than expected, and yet investors have felt comfortable buying US stocks.
They have not, however, shown any comfort about buying stocks from anywhere else. The tightening labour market and the higher rate expectations that come with it have put pressure on emerging market assets.
Since April, the MSCI EM index has lagged the S&P 500 by more than 21 per cent. EMs have now given up all the outperformance they had logged since 2003. The strength of the dollar continues to subject many of them to near-crisis conditions.
Is this “revulsion” at last? It certainly looks as though EMs could be entering the revulsion phase.
Making a short-term bet on EMs means making a bet on the immediate future of the US labour market. The rates environment could get worse before it gets better.
In the longer term, for those who can genuinely put money away and leave it for a decade, there have been many worse times to enter EMs.