Price pressures threaten bond markets
It’s been an action-packed week, with the US seeing much weaker than expected employment numbers, a shutdown of the massive Colonial Pipeline following a cyberattack, and even bigger numbers for fiscal spending coming out of the Biden administration. A big week for data lies ahead. In the UK, the elections were seen as a victory for Boris Johnson, and in economic news the Bank of England hiked up their UK growth forecast.
In this update, I’m going to discuss inflation and the prospects for bonds.
Let’s start with those employment figures in the US. The market was expecting 1 million new jobs, yet the outturn was less than 300,000 and the previous month’s increase was revised down. Signs of a weak labour market? Not at all. It seems that the numbers reflect a shortage of labour – something normally seen at the very peak of the economic cycle, not one where employment is still 9 million below its pre-Covid peak. With extended unemployment benefits from the Federal government, many workers are reluctant to accept low-paying jobs. The sheer speed of the economic turnaround is probably also to blame. And the statistics are probably distorted by seasonal adjustment problems. Surveys show businesses are finding it very hard to recruit new staff – very hard – and they are being forced to offer higher wages, especially in hospitality. With rising commodity process and supply constraints in manufacturing associated with a shortage of semiconductors, price pressures are likely to increase. That’s certainly what the markets are saying, with 10-year breakeven inflation rates pushing above 2.5% for the first time in 10 years.
So why have US Treasury yields have fallen in the last few weeks? The answer is that the US Federal Reserve have been keeping real yields – the TIPS yields – down via their quantitative easing programme. In fact, there’s been a 32 basis point decline since late March. We don’t think this can continue, and conventional yields are headed higher, towards 2%. That will still leave them below actual and prospective inflation – hardly a high number. Although this will cause a few wobbles for equities, it’s more of a headwind that a serious threat.
Back in the UK, the furlough scheme has limited the rise in unemployment, but the labour market seems to be exhibiting similar signs of shortage; there are offers outside almost every pub pleading for staff. Many potential employees have decided to stick with their new jobs in other sectors, many non-UK-born workers have gone home, and similar to the US, the speed of the turnaround is creating shortages. The UK boom is set to intensify as lockdown restrictions are eased and this problem is likely to get worse. Inflation pressures are set to rise here too. This should put upward pressure on gilt yields and strengthen sterling.
We should emphasise that we expect these price pressures in the US and UK to be temporary…but you never know if you’ve reached a peak until you begin the descent, so there’s tricky few months ahead.
Equity markets are emerging from another blowout earnings season, and investors might just be a touch complacent. We still think risk assets will outperform, but we could be in for a volatile summer.