Many market observers have been predicting a sharp rise in US real yields for at least a year (ourselves included). In 2021 it never quite came. That was mostly because resurgences in Covid infections regularly triggered rallys in US Treasury bonds. Will 2022 be different?
This time, it may be for real. While we certainly do not belittle the risk to the economy from future coronavirus variants, the pattern with Delta and Omicron has been that the economic impact of each new strain has been progressively less negative.
At the same time, the messaging from the US Federal Reserve on its monetary policy stance has clearly changed.
Whereas last year, the central bank’s view was that higher inflation would prove transitory, it has become increasingly clear that at least some of the price pressures will persist. While Covid may be fading (slowly) as a macroeconomic factor, the supply chain disruptions will likely linger.
More importantly, the US labour market appears to be near full employment, meaning that recent wage gains could last for longer. To the degree that the Fed is behind the curve in terms of tackling inflation, we believe the risk now is that the bank raises its policy rate by even more than the market already expects (see Exhibit 1).
US labour market – In better shape than it may look
Many observers viewed the latest US non-farm payrolls report as disappointing. Only 199 000 jobs were created in December versus a consensus forecast of 400 000. The disappointment, though, was more due to overly optimistic expectations than to a surprising slowdown in job growth.
It is important to recognise the surge in Covid infections that occurred during the month (and which has worsened since). Whenever this has happened in the last two years, job growth has slowed sharply. This has been the case particularly in those industries sensitive to lockdown restrictions or people’s nervousness when the risk of infection appeared to be high. As the Omicron wave passes, we expect job growth to rebound.
Other indicators suggest the labour market is in fact quite strong. Even though the participation rate edged up in December (although not among older workers), the unemployment rate fell, meaning a greater share of those people re-entering the labour force found jobs.
This offsets some of the pessimism around the high ‘quits’ rate that reflects the number of people who are voluntarily leaving their job. This ‘great resignation’ is a positive sign of the dynamism of the US labour market.
We all appreciate that society and the economy will in many ways be fundamentally different in the future due to the pandemic. That means the labour market needs to be reconfigured. So many people quitting (and presumably taking new, better jobs), suggests this reconfiguration is happening quickly (and in contrast to Europe, where stability comes at the cost of economic dynamism).
Market segments benefiting from higher rates
Strong consumer and business demand combined with lingering supply chain constraints and a smaller labour force are the factors driving inflation to higher, sustained levels.
At a minimum, US monetary does not need to be accommodative (as it is today). A return to even a neutral policy rate would still imply real yields that are perhaps 75-100bp higher than they are today.
The potential impact of such an increase is already evident in the market moves over the course of the real yield sell-off this month. Indices with a positive sensitivity to higher rates such as those for value stocks and commodities have outperformed, while assets at risk from higher rates such as technology stocks have lagged sharply (see Exhibit 2).