Is it hot in here, or is it just the bond market? I remember a time when generating jobs was a good thing. Apparently, we are past those days of old. Good news is now bad news. As usual, the Labor Department released its official employment report this morning providing an update on the American labor situation. The economy added 200k jobs in the past month as opposed to the 180k jobs that was expected. You would think that is a modest surprise to the upside. Instead, we saw what is being termed by some as a “controlled panic” in the bond market and a sell-off in the equity market which almost matches the maximum drawdown in all of 2017. The yield on the 10yr US Treasury bond jumped about 5 basis points, or 0.05%, right after the report was released. It hardly sounds like a panic move, but as we have acknowledged in prior write-ups the increase in rates has been a steady grind higher for some time. In the past month, the yield on the 10yr benchmark rate has increased just under 40 basis points (0.40%) and almost 80 basis points (0.80%) since the most recent trough just above 2% in September. The cause? Increasing inflation concerns. As the yield on the fixed rate US Treasury bond has moved higher, the “real yield” (as proxied by Treasury Inflation Protected Securities or TIPs whose yield floats based upon changes in the Consumer Price Index) has risen much less. That means that market expectations for inflation (implied by the difference between the fixed and inflation-adjusted floating rate) are on the rise which in turn is fueling fear that the Fed will be even more aggressive than the 3 hikes for 2018 they have communicated (and the market has come to slowly accept). Today’s job report added to the fire, specifically seeing wage growth up 2.9% year-over-year. Wage growth is a more sustainable source of inflationary pressure than say fluctuation in energy prices which tend to be volatile. The markets (bond and equity) are worried that the inflationary case builds enough to where the Fed finally takes the punch bowl away from the party.
We remain in a wait-and-see mode. It is normal for equity markets to fluctuate. It is also normal that when an equity market has rocketed up quickly, that it retrace some of its gain especially in sectors or names that have moved the farthest. Inflation expectations firming up to the 2-3% camp is also normal despite the past several years after the financial crisis where it seemed like monetary policy makers could not create inflation no matter how much money they printed. What is not normal is what we saw in 2017 where the maximum equity market drawdown was less than 3% all year long and the complacency that comes with too low of volatility. The same complacency existed in the bond market. Looking at fund flows, the bond market has seen significant inflows year after year despite yields moving lower and interest rate risk (duration) increasing. January will be the first month in a while that bond investors will open a statement that shows some losses in bonds. It is healthy to remember there is risk in the market. That said, the biggest risk is that of a policy misstep, especially at the Fed. To that, we hope that the incoming Fed Chairman Jay Powell maintains patience yet vigilance. Wage growth is good for an economy and for employment which, despite low headline rates, suffers from a lack of participation in the labor force. If he is the one to pull back support too early, he will be in the hot chair.