Our US economist Steve Blitz continues to argue that the Fed is as confused as anyone over the drivers of inflation in general & in particular what the real neutral rate( ‘the inflation-adjusted level of the federal funds rate consistent with keeping the economy operating on an even keel’) should be. Contrary to the Fed Steve believes it might actually still be below zero given the still sluggish pace of capital spending by businesses & households. Although importantly we now do expect an imminent notable pick-up in domestic capex , irrespective of any Trump tax incentives.
Indeed the Fed has been waiting for just such a pick-up in the demand for capital that will raise real rates as one of their roadblocks to normalising rates has been the late summer collapse in US TB 10 year real yields which fell 40bps under the weight of Chinese buying at a point when US economic growth was accelerating! Bringing forward QT was done partly in the hope that this would push yields higher again allowing the Fed to hike without coming close to precipitating an inversion of the yield curve.
The September data imply that finally the upturn in capital expenditure is gathering momentum which should prompt sufficient yield curve steepening for the Fed to raise rates in Dec, March & June-regardless of who the next chair is. Importantly although we are thus much more hawkish than the market we only expect US 10 year TB yields to grind higher to 2.8%( a 50 bps reversal of the QE induced term premium compression),to be followed by further yield curve flattening and not a bear market in US bonds just yet.
Fed to hike in December – March and June too
Market participants still don’t respect the Fed’s view of all things economic. They attach a near 90% probability to a 25bp hike at the December 13 FOMC meeting, meaning a 10% chance of a random event that stays the Fed’s hand. As for another 25bp in March 2018, the odds are set at 32%, and there is only a 13% probability of the FOMC going another 25bp next June, which would take the funds rate to 2%. Lowballing the Fed’s trajectory has been the right bet throughout this cycle. The way we see the economy unfolding in the coming year, we believe the Fed gets to a 2% funds rate by June, regardless of who the next Fed chair is.
Our viewpoint is rooted in earnings and, by extension, wages, as we saw in September, though not in the published BLS average. This measure is weighted by sector employment and so was boosted in last Friday’s employment report for September by a sharp decline in restaurant workers, who make about $13.50/hour against a national average of around $24. Rather, we were struck by the momentum in our own unweighted average and in pay for a number of industries. Wage momentum is rising in most sectors, and this argues strongly for the Fed to raise policy rates in December.
With profits improving, pay should continue to reaccelerate into yearend and continue into 2018. One caveat is that the forces of globalisation and technology are still holding back the pace of wage gains (in many cases the two forces are one and the same) – notably in industries that are most impacted, including manufacturing and financial services. As a consequence, the pace of pay increases may still broadly disappoint relative to the revival in earnings, based on historic relationships.
The economy has given off mixed signals this year, reflecting leading and lagging sectoral responses to the inventory cycle in 2015-16 that helped create a small profits recession. Since then, manufacturing has picked up but wages growth slowed in response to weaker earnings. As a result, retail spending growth has pretty much spun in place. Commercial construction, also a lagging indicator, has slowed, and singlefamily housing, strong earlier in the year, has begun to tail off some of late.
Considering how the global economy continues to expand, as does domestic industry aside from autos, our expectation is that next year the various sectors of the economywill all be growing. At the same time, the cost of carry for non-financial firms (nominal growth in final sales minus the rate on prime commercial paper) remains more than favourable to expansion.
Against this backdrop there is little justification to keep holding the federal funds rate below core inflation. In addition, while the equity market is currently not overvalued by our measures (nor is it cheap), as growth continues there is a good chance that inflows, undeterred by higher short rates, could propel share prices into seriously overvalued territory. Confidence in growth, wage hikes and QT should also push up term yields to steepen the yield curve a little and thereby create some runway for the Fed to act. A higher core rate of inflation would also help in this regard by lowering the real funds rate.
As such, a 2% funds rate next June would be, at worst, about 25bp above core inflation with the core rate trending higher and wage settlements accelerating. This is not a very bold or constrictive level for policy rates. And we haven’t even mentioned the likelihood of some tax cut.
Capital demand pushing Fed… to higher rates
The FOMC has been anticipating accumulating signals of improved demand for capital that will raise real rates, albeit slowly. They are focused on the business side, figuring that jobs, income and demographics will eventually raise consumer capital spending (ie, on new homes). September data for durable goods indicate their recovery from the 2015-16 slowdown is accelerating. Last month’s rebound in new home sales, related to the hurricanes that hit Texas and Florida, confirms that average sales are back to their long-term median pace of 600,000 units SAAR and are drifting higher.
The slump and recovery in new orders for non-defence capital goods ex-aircraft, also evident in other figures such as wholesale sales ex-oil and autos, are what the Fed should keep in mind when figuring out why 2017 data on growth, wages and inflation seem so mixed up (to them). For a good chunk of the economy, 2017 is the first full year of recovery; at the same time, the knock-on impact of the 2015-16 downturn has been slowly rippling through various sectors. From our perspective, positive growth trends in different parts of the economy are starting to get back into sync. This should be increasingly evident in the coming months, lifting wages and eventually inflation in its wake.
To be clear, not all corners of the durables industry are recovering. Computers, electronic equipment and appliances have not yet turned up. But new orders for primary metals, machinery, fabricated metal products and communication equipment are back in their 2011-14 ranges with inventories in line.
The longer-term picture shows that the level of nominal new orders has effectively been capped since June 2000, even though almost all other nominal indicators of economic activity have reached successive new highs with each cycle. The reason why durable goods orders haven’t kept pace is not immediately apparent, but the point is they have a lot more scope to increase and, in effect, catch up with the rest of the economy. When that begins in earnest, real yields on 10-year maturities should begin to rise and steepen the yield curve.
On the housing front, there is also reason to believe the peaks for this cycle have yet to be reached. After an extended period of overbuilding and subsequent recession that caused demand to plummet, the recovery in the number of 25- to 34-year-olds with a job, as measured by Y/Y percentage growth has finally gone on long enough to hoist new home sales back to their long-run average of around 600,000 units SAAR. Yet the employment/population ratio for this age group is not quite yet back to its pre-recession high and is still below the 2000 peak. So it is reasonable to presume that Y/Y growth in the number of those employed in this age cohort can be sustained in the 2%-4% range. In addition, the longer they are in work the more their incomes and credit scores rise. If all this comes to pass, and we believe it will, new home sales should slowly trend up towards 800,000 – the top of the cyclical range before mortgage madness took over.
What the September data imply is that the upturn in capital spending that the Fed has been waiting for (or revival in durable goods, to be more exact) appears to be gathering momentum. With that, the yield curve is set to steepen enough for the Fed to raise policy rates in December, March and June – regardless of who is the next chair. We haven’t weighed in yet on the rest of 2018 because we don’t yet know the extent to which federal tax cuts and spending increases will aid and abet growth in the coming year.