Waiting for wages growth

Cameron Rae
Cameron Rae Laminar Capital & Easterly Asset Management

Higher wages growth in the United States seems to have caused the sell-off and subsequent sharp lift in volatility in global bond and share markets. Annual growth in in US average hourly earnings accelerated to 2.9% y-o-y moving in to territory that has presaged higher inflation in the past and more aggressive Fed policy tightening. Bond and share markets were still pricing for a future characterised by strong economic growth, but with inflation still relatively subdued and slow” normalisation” of interest rates. The January average hourly earnings report, although not really a surprise coming after a slew of reports over several months indicating strong US economic growth and an ever-tightening labour market, was enough to jolt markets in to recognition that US interest rates, including the funds rate set by the Fed, may lift back to “normal” more quickly than markets previously considered likely.

“Normal” interest rates in the US imply compensation for inflation which the Fed expects to settle around 2% later this year plus around a 1% to 1.5% real premium on top. The Fed in the dot point forecasts of the funds rate provided by its senior officials places the Funds rate – currently 1.50% - at 3.00% by the end of next year. In other words, the Fed’s dot point forecasts indicate it plans three 25bps rate hikes in 2018 and another three 25bps hikes in 2019. These forecasts are based on inflation picking up slowly.

If strong US economic growth is starting to boil over in to labour supply constraints capable of promoting inflationary wage increases the Fed would be forced to act more quickly than its current plan lifting the funds rate. It is this threat that the US bond market is starting to fret about and the risk is that bond yields rise more quickly and further than the Fed hikes in the funds rate. It is not just the changing inflation outlook that is causing US bond yields to rise, there are also questions about the ability of the market to cope with Fed sales of bonds (the reversal of its QE purchases) and an approaching blow-out in the US budget deficit too on President Trump’s budgeted tax cuts .

It is hard to say how much further US bond yields will rise over the next few months, but if as seems very likely wages data throw a few more upside surprises fueling fears of higher inflation and a more aggressive Fed tightening program, US bond yields of all maturities could rise above 3%.

In Australia, the situation relating to the interest rate outlook is different from that in the United States in the sense that although the local labour market has tightened it has not reached the point yet of pushing up wages and threatening higher inflation. The RBA left its cash rate unchanged at 1.50% at its policy meeting last week (the last rate change was a 25bps cut in August 2016) and in subsequent comments including in the Quarterly Monetary Policy Statement has made it plain that it still expects low wages growth and low inflation to persist for a while yet. The RBA also expects that further tightening in the labour market will eventually lead to higher wages growth and higher inflation.

The RBA has also become more candid that it will not hike the cash rate until there are much stronger signs of faster wages growth. Our view is that signs of faster wages growth are likely to show through in the second half of 2018 implying a first RBA rate hike say in August. If wages growth takes longer to show signs of picking up, it is possible that the first RBA rate hike may be delayed until early 2019.

Rather like in the US, once signs show of faster wages growth in Australia, the local bond market may start to expect a sharper rise in inflation and an aggressive policy tightening cycle by the RBA. The RBA has indicated that the neutral or “normal” cash rate is around 3.50%. There is a risk that once the RBA starts hiking the cash rate it may need to get the cash rate up towards the neutral rate relatively quickly.

Over the next few months it is highly likely in our view that US bond yields will mark higher on further signs of strong US wages growth and heightened inflation risk. Australian bonds are likely to be influenced by US bond yield movements but movements in Australian yield may be modest by comparison because the threat of higher wages growth and higher inflation is less in Australia than in the US for the time being. There may come a period down the track (possibly as early as Q3 2018) where the reverse is true and the higher wage/inflation risk is more pronounced in Australia than in the United States and Australian bond yields rise relatively more than their US counterparts.

The bottom line, however, is that interest rates will move higher, in our view, in 2018 and 2019 and financial markets are likely to adjust further to a higher interest rate outlook.

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