This week’s Federal Open Market Committee (FOMC) meeting will be closely watched for further clues on the Fed’s thoughts on tapering. Will the FOMC stick with ‘thinking about thinking about’ tapering, or will the meeting provide some clarity on a timeline?
We don’t think investors will get ahead of themselves here. Perhaps the best we can expect is some slightly more detailed guidance on the conditions that need to be met before the Fed will consider tapering initiatives. What we will probably see is a continuation of the message that the Fed chair, Jerome Powell, has been giving for some time now: substantial further progress on inflation and employment goals is needed before the Fed will look to trim its $120bn of monthly bond purchases. Could this meeting, however, be the one where Powell signals he and his fellow FOMC members are ready to talk more practically about tapering options?
As bond investors, like many we have been trying to weigh up the emergence of inflationary pressures seen in recent US Consumer Price Index (CPI) data against a more measured improvement in employment figures. The CPI number for May at 5% year-on-year marked the biggest increase since June 2008 (core CPI at 3.8% was the biggest increase since 1992). As with April’s 4.2% print, base effects played a major role in the elevated May number but reopening momentum and supply chain pressures also contributed, as did airfares, food produce, hotel lodging and apparel. Perhaps the biggest contributor has been the effect semiconductor shortages are having on the second hand car market. Used car prices shot up another 7.3% in May following a 10% jump in April, and used car prices alone contributed some 1.1% to the May CPI figure. Some of these price gains will no doubt be transitory, but where demand is grossly outpacing supply inflation concerns are prevailing.
Turning to employment data, the US has a staggering 9.29m job openings according to the May figures released by the US Bureau of Labor Statistics. In terms of those looking for work, the number of people not in the labor force who currently want a job sits at 6.6m. However, the recent non-farm payrolls (NFPs) numbers were lower than expected at 559k for the month of May; higher than April’s disappointing 266k, but given the pace of economic recovery we wouldn’t have been surprised to see month-on-month (MoM) growth of around 1m jobs at this point. Many reasons for this lag have been offered and generous unemployment benefits are one of the prime suspects, but these benefits are beginning to roll off in numerous states. Weekly $300 stimulus checks are being halted early by 18 states in June and a further six in July, which taken together account for nearly 30% of all unemployment benefit recipients, with the remainder set to expire in the first week of September. We would expect an improvement in the job openings data as stimulus falls off and children return to school (childcare being another likely drag on returning to the workforce). We have also seen a pick-up in wage inflation, as measured by MoM average hourly earnings data, which evidently still hasn’t been enough to incentivize a majority of the unemployed back to work.
With all of the recent data pointing to higher inflation expectations and the Fed expected to maintain a transitory interpretation, we will be focusing our attention on comments from the various regional Fed presidents on conditions that could prompt a tapering move at some point in the future. It is here that we expect to hear a little more detail, especially since several of these prominent FOMC members have recently been vocal about the need for tapering dialogue at upcoming meetings. Given the move to unwind the Fed’s SMCCF corporate bond holdings we should expect the next logical step to be a gradual timeline on unwinding the QE packages, even if it ends up being a 2022 event.
All this considered, it is worth touching on the recent rally in 10-year Treasury yields to below 1.50% over the past week and why they haven’t been moving in the other direction, which is what you might expect at a time of record-setting CPI numbers. There are a number of plausible explanations for this and it is impossible to know which is having the biggest impact. Firstly, short positioning in longer dated Treasuries recently hit elevated levels, leaving the market ripe for a squeeze. Secondly, foreign investors have been seen purchasing Treasuries on the back of a weaker dollar (and cheaper dollar hedging costs). Thirdly, we have heard that there has been a pickup in domestic pension fund buying as fully funded percentages improve. Another reason has centered on China’s efforts to counter the surge in commodity prices by opening up some of their metal reserves, offering copper, aluminum and zinc to end users and leaving increased dollar reserves that need to be invested somewhere. Finally, another suggestion is that on the back of the reasonably muted non-farm payrolls data in May, inflation concerns have been tempered or may have even peaked.
Again, we remain extremely wary of higher duration bonds given our view that the potential persistent inflation suggested by recent data isn’t priced into US Treasury yields, and we aren’t expecting anything we hear from the Fed this week to change that view in the near term.