The forward-looking element in this exercise comes from analysing the nuances (i.e. the role of contraction in the labour force and its drivers) behind the sharp fall in the unemployment rate witnessed over the last 14 months. Based on historical evidence this would seem to imply forward looking wage pressures, as the labour market tightens. Here, Chairperson Yellen’s dovish arguments are predicated on the idea that the current low level of labour force participation has a strong cyclical component. In our view, if the Federal Reserve continues to keep its accommodative policy stance despite the significant improvement in the labour market, then an improvement in aggregate demand would help discouraged workers back into the labour force. This in turn should keep wages in check and allow the Fed to keep monetary policy easy given the lower risk of inflation.
Given the focus on wages, the average earnings growth data has become, in our view, critical in assessing the next move in Fed policy and, currently, the latest readings imply that the central bank has little to worry about.
USD starting to connect with fundamentals
Given the conflicting narrative around cyclical vs. structural dimensions of the US economy, clearer trends are starting to appear in the FX space, with the USD starting to gain ground in the G10 space. The monetary easing initiated by the ECB has been a critical factor in turning the tide, coupled with evidence of a slowdown in flows to the periphery, after the ECB-led carry binge. Interest differentials continue to favour the USD, given the unquestionable structural backdrop of the Eurozone economy mired in chronic disinflation and weak recovery.
In addition, positioning withstanding, the cyclical upswing in the US economy remains a strong support factor, while the ECB is likely to face pressure for another round of easing in coming weeks given the very subdued inflation picture.
US bond yields - experiencing pull vs. push
Given the above backdrop, we believe the situation in the US bond space is more ambiguous. The push factors are coming from the cyclical upswing in the US economy together with the strength of the labour market. As discussed above, this appears to be offset by the strong emphasis on the output gap and existing slack in the economy by the Fed’s core leadership, which is focusing on wage growth as a policy target variable. We continue to think that the upswing in the US economy is genuine, and wage growth is likely to appear in coming months, forcing a change in Fed policy (something Chairperson Yellen has indicated is possible if data shifts). However, until concrete evidence appears, it appears that “neither here nor there” dynamics are likely to continue for now.
In terms of key events, we have the Jackson Hole conference at the end of August, where the focus will be on the labour market, while the Fed ends its QE3 programme in September and an exit manifesto is expected to be released. If the recent trajectory of cyclical data continues, then we think that risks in rates are firmly to the upside.
Geopolitics - the wild card
Geopolitical developments remain the wild card in the current environment. As we discussed in a recent note, we think that the potential of sustained systemic risk stemming from the Ukraine issue remains low. This is due to very strong economic inter-relationships (a dynamic which has been playing out so far). However, news of Ukrainian forces making headway in the East have raised the risk of further escalation in the short term. If this were to happen (not our base case), we believe the rise in interest rates that we expect in coming months is likely to be delayed as safe-haven positioning takes over. However, in the FX space, such an impulse is yet again USD positive. This is due to stronger economic relations between the EU and Russia and the impact on expectations of ECB policy and the USD’s role as reserve currency.
Salman Ahmed
Global &
EM Fixed Income Strategist
Lombard Odier Investment Managers
