There are lots of moving pieces right now. So many that few wanted to step in front of last week’s selling on Wall Street. I am going to try to sort out some of these pieces here.

Continued here as a newsletter…

The employment report and, most notably, the pop in wages caught analysts off guard. If you were expecting the job market to slow down early this year, you continue to be on the wrong side of the story. Employers added 200k workers to payrolls in January, close to the three-month average of 192k. Curiously, the unemployment rate has held steady for four months in a row despite job growth well in excess of labor force growth. To be sure, those numbers come from different surveys, so they don’t need to match up month to month. Still, I think the household survey will eventually catch up and hence we should be prepared for a sharp lurch downward in the unemployment rate in the coming months.

Wage growth accelerated to 2.9 percent year over year, a sharp rebound. I think there are two stories to tell here. First, 2.9 percent by itself isn’t cause for concern that labor markets are overheating. If inflation were at 2 percent, then real wage growth would be 0.9 percent, which is pretty much in line with productivity growth. In other words, this isn’t an inflationary reading on wages. Moreover, hours worked slipped, setting the stage for a productivity boost in the first quarter. Higher productivity growth, even just 0.5 percentage points, would help support nominal wage acceleration in a continued low inflation environment.

The second story, however, is arguably more disconcerting for bond traders. Annualized wage growth in four of the last five months exceeded 3 percent. In two of those months the gain was more than 5 percent. The three-month moving average is a 4.1 percent gain. That marks the fastest three-month gain since 2008. This solid pace over the last several months suggests that the January number is more than just higher minimum wages. If this trend continues, the Fed will tend to see such numbers as evidence that the economy has pushed excessively past full employment.

To be sure, such wage growth doesn’t have to be inflationary – productivity could leap higher to above 2 percent, or profit margins squeezed. Or some combination of the two could come to pass. But any way you look at it screams caution in the near term until it all gets sorted out. Consider these possibilities:

1. Wage growth acceleration indicates an overheating economy. The risk here is that the Fed turns hawkish and accelerates the pace of rate hikes. This puts upward pressure on the yield curve in the near term while in the medium term supports renewed flattening as the Fed tightens policy to restrain growth. The risks of a policy error rise, and with it the risk to corporate profits.
2. Wage growth indicates productivity growth is accelerating. Under this circumstance, the neutral rate is likely moving higher and the Fed will feel compelled to chase that rate. That argues for an upward shift of the yield curve. Higher real rates would likely pressure asset valuations more broadly, weighing on equity prices.
3. Wage growth acceleration eats into profit margins. This is a complicated space for the Fed. Margin compression would weigh on equity prices and financial conditions more broadly, which would tend to ease pressure on the Fed to hike. On the other hand, central bankers would be wary that eventually firms would be forced to pass on higher costs. In other words, margin compression would provide only temporary relief from the inflationary pressures of an overheated economy. The Fed would thus need to accelerate the pace of rate hikes.

Under any of these circumstances, I think Gavyn Davies at the Financial Times is correct that the end of deflationary bets means the term premium has moved higher as well. Altogether then what it looks like is that the economy is shifting into a new equilibrium and with it the constellation of prices (goods, assets, interest rates, exchange rates) are all shifting as well. And while that shift occurs there will be periods of uncertainty that will be negative for dollar assets. That uncertainty will remain until there is more clarity with regards to the path of economic activity.

If all of this wasn’t enough, market participants are also watching for an increased supply of US Treasury debt plus a simmering political crisis in the US that looks increasingly likely to boil over in the weeks ahead.

My sense is that much of the shifting is cyclical rather than secular and as such I don’t see ten-year yields jumping to 4 percent and instead expect much more resistance as 3 percent is crossed. That said, I can certainty understand where market participants are wary about reaching out to catch that falling knife.

Two central bankers spoke up during last Friday’s sell off. San Francisco Federal Reserve Bank President John Williams said that the economic forecast remains intact and hence the Fed should maintain the current plan of gradual rate hikes. He does not think the economy has “fundamentally shifted gear.” For what it is worth, it is my impression that Williams is slow to update his priors. His colleague Dallas Federal Reserve President Robert Kaplan also retains his base case of three rate hikes in 2018, but opened the door to more. My sense is that Kaplan is sensitive to the yield curve and will tend toward chasing the long end higher.

Also, if the economy is shifting gears, watch for St. Louis Federal Reserve President James Bullard to warn of an impending regime change in his model and with it a possible sharp upward adjustment of his dot in the Summary of Economic Projections.

Bottom Line: If as I suspect much of what we are seeing in the economy is a cyclical readjustment, then long term yields will likely reach more resistance soon while short term yields will continue to be pressured by Fed rate hikes this year and beyond. If the Fed turns hawkish here they will likely accelerate the inversion of the yield curve and the end of the expansion (this could be the ultimate impact of the tax cuts – a short run boost to a mature cycle that moves forward the recession). If a more secular realignment is underway, long (and short) rates have more room to rise. It is reasonable to be unable to differentiate between these two outcomes as this juncture.

Big data day coming up with the monthly employment report. Most likely the report will not yield anything to prevent the Fed from raising rates. 

Continued here as newsletter…

What to expect from the report? Consensus expectations for payroll growth remains at 175k in a range of 150k to 205k. The ADP report suggests the consensus is too pessimistic. Of course, the same could be said of the last report as well. That said, my expectation is that the report is more likely to surprise on the upside rather than the downside. Note though that even a report that falls short of expectations like last month (payroll gain of 148k) remains sufficient to keep the Fed on track for further tightening.

Wall Street also expects the unemployment rate will hold constant at 4.1 percent. Here again I think the risk is weighted toward a better number. Job growth continues to run ahead of labor force growth; eventually this will translate into a lower unemployment rate. Remember that the unemployment rate is already just a small step away from the Fed’s year end estimate of 3.9 percent. A 0.2 percentage point move in a single month is not in any way outside the realm of possibilities. All else equal, such a move would place upward pressure on the Fed’s rate forecast.

Of course, all else is almost never equal. Continued tepid wage gains would likely induce further reductions in the Fed’s longer-run unemployment estimates. And tepid wage gains are expected to continue with Wall Street anticipating just 2.6 percent higher hourly earning relative to last year.

Part of the low earnings growth can be attributed to low inflation. Part can also be attributed to low productivity growth. Compared to a year ago, real output per worker in the final quarter of 2017 was up just 1.1 percent. Note that real hourly earnings growth for all employees was up just about the same amount at 0.96 percent. In short, real wage growth remains stuck at just where you might expect it to be given productivity growth and inflation.

Even with low productivity growth, in theory real wage growth could accelerate if labor markets remained sufficiently tight to drive up nominal wages but competitive pressures were sufficient to restrain inflation. The difference would come from profit margins, which would likely weigh on equity prices. Still, it is not yet clear that the Fed is willing to run that experiment.

Finally, note that the still low productivity numbers suggest the economy remains in a low r-star world. That suggests some caution is assuming the upward pressure on long yields can be maintained.

Bottom Line: Employment report will keep the Fed on track. Most likely it will entrench expectations of three rate hikes this year. Relative to consensus expectations, I see the risks as weighted toward raising the probabilities of more rather than less. 

As anticipated, the Fed left rates unchanged at the conclusion of yesterday’s FOMC meeting. The statement was little changed but the handful of revisions point to continuing rate hikes. The Fed remains on track for three 25bp rate hikes in 2018. For the most part, the turnover at the Fed combined with ongoing solid data has left the remaining doves sidelined. The low inflation warnings of last year were largely a head fake as the Fed was always positioned to continue raising rates as long as there looked to be continuing downward pressure on unemployment.

Continued here as a newsletter…

The FOMC statement was largely unchanged compared to December. The Fed dropped the hurricane references as they were no longer relevant for the outlook. The Fed revealed additional confidence in the inflation outlook by dropping the reference to low near-term inflation in place of an expectation that inflation will rise this year. The firming of recent inflation numbers likely influenced this change although it was evident in the Fed’s forecast from December.

Risks remain roughly balanced; they did not delete the “roughly.” They are still watching inflation developments, but note that this can cut both ways. Last year it arguably reflected the influence of doves worried about low inflation. Now it could be interpreted as the influence of hawks worried about high inflation. In either case, the Fed remains data dependent.

More curious was the addition of the word “further.” As in:

The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. 

It would be nice to have had a press conference to see if there was any significance to this change. In my view, the reason for this change was to dissuade anyone from thinking the Fed was done hiking rates.

Arguably then you can say this statement is more consistent with the message of the SEP than the last statement. The message of the December SEP was that inflation will climb in 2018 and so too will rates. The December statement was arguably a bit mushy on both points. The January statement thus clarifies the likely path of policy.

So maybe we should read the January statement as an effort to make the statement more consistent with the forecast? And that this was easier to accomplish with some of the more dovish voices rotating off as voting members? Something to get some clarity on in the coming weeks.

In other news, the Fed also updated its “Statement on Longer-Run Goals and Monetary Policy Strategy.” The notable change was the Fed’s estimate of longer-run unemployment fell from 4.8 percent to 4.6 percent. This change makes the statement consistent with the December SEP. I sense a theme here. A bigger takeaway is that the Fed continues to show flexibility in revising their estimates of longer-run unemployment in response to tepid wage growth.

Oh, the FOMC also selected incoming Federal Reserve Chair Jerome Powell to be the chair of the FOMC. But you kind of saw that coming.

Meanwhile, we still have plenty of data coming up as the week winds down. Today the BLS released the Employment Cost Index for the final quarter of 2017. Total compensation costs for civilian workers was up just 2.6 percent compared to a year earlier. The direction of gains remains up, but the magnitude remains tepid. There is no reason here to believe that labor costs are rising at a rate suggestive that the economy has breached capacity constraints. That argues for continued policy gradualism.

Note that to the extent firms face rising labor costs, they may become increasingly interested in expanding or relocating in lower cost regions. This is another mechanism firms can control costs and keep an lid on inflation. See Pandora for example.

ADP reported private sector job growth of 234k for January. This may induce some upward revisions to consensus estimate – currently a 175k payrolls gain – for Friday’s employment report. (Although that bet didn’t work out too well for the December report). Of course, the current consensus, if realized, would already be sufficient to keep downward pressure on the unemployment rate. The Fed thinks they need to get to something closer to 100k to guide the economy to a sustainable place. I don’t see a reason to think we are getting there anytime soon, and that will keep pressure on central bankers to raise rates.

Bottom Line: The Fed is set to hike rates in March. I continue to believe that the hawkish tilt of the FOMC should entrench forecasts of three rate hikes in 2018 and that it is premature to conclude four or more. I don’t see reason yet to think the Fed is about to conclude they are behind the curve if they retain the current projected policy path.