We are now starting to see some things in the economy that we have never seen before:

  • Last week, I mentioned some potentially widespread examples of wage declines in particular industries. I think in the past we may have had only a few industries here and there go through wage declines, so the overall wage picture was clearer in tight job markets.  But the advent of technology, globalization, price discovery and improved models of doing business have all contributed to downward pressure in wages (and even negative wage growth) in MANY industries.  So we have a heterogeneous wage picture in the economy, where the overall result is unimpressive.  And let’s not forget about inflation…
  • We have had goods deflation for what I think must be YEARS. I remember writing about it in the early days of the CA, and it’s still the case now.  Firms involved with goods just have ZERO pricing power.  The CPI for commodities (goods) less food and energy was MINUS 0.6% yoy while for services (less energy) was 2.5% yoy.  Looking forward, vehicle sales (both new and used) are going to be in the toilet for some time because of the inventory drag.  And we just have to look at Amazon, Alibaba, Walmart, Aldi, Lidl, to see that in the current environment, you should not expect any goods inflation.

A “tight” labor market has not translated into wage gains.  Do we need to rethink the previous relationships between the labor market, growth, productivity, wages and inflation?  We are used to things moving in a certain way… high employment leading to higher wages, leading to higher retail sales and leading to higher inflation, etc.  I’m not sure this is going to be the case anymore.

Can you have a “strong” economy with low inflation?  The answer is probably “yes” – I think any time you have almost 200K per month growth in employment, that’s pretty strong, regardless of what inflation reads.  However, I’m not sure the Fed needs to hike much if there is no inflation.

So what does this mean for trading?  I think we may need to look at the curve from the perspective that we may not get any kind of noticeable wage or inflation pressure in the near-to-medium term.  If we get some, that will just be a bonus (assuming we are bearish).

Last week, I said I wasn’t sure about the direction of rates in the short term.  It was reasonable to think Yellen was going to express some concerns about inflation.  Considering the economic data had been surprising lower for months now, I suppose it wasn’t too surprising we kept getting downside surprises to CPI and Retail Sales.  So the bears taking some profit ahead of last week made sense.

We now enter a “dead” 1.5 weeks until the FOMC meeting, and we should get a good read as to whether the markets want to follow the tapering story (longer end steepening), or the economic weakness story (front end flattening).  I would think that with US and EU tapering on the horizon, the very long end should stay steeper.  It would be a bad sign for bears if the very long end bull-flattened from everyone grabbing for yield.  Conversely, if the front-end can’t flatten on weak inflation and weak retail sales, that’s a bad sign for bulls.

There are two ways for the curve to steepen: (1) more hikes priced in, (2) more term/risk premium put back in the curve.  For the former, inflation and Retail Sales have the potential to rebound quickly if the economy is fine.  All it would take is some kind of oil spike, trade war, strong seasonal demand (back-to-school, Black Friday, Holiday sales, etc), or even fiscal stimulus (gasp).  So the markets’ perception of the economy could change very quickly.  Whether any of this happens is the question.  The latter could happen if someone who was long fixed income (like the Fed or ECB) decided to stop buying.

It is becoming clear that the next Fed move is going to be tapering FIRST.  Could persistently low inflation keep the Fed from tapering in September?  I believe “yes,” which is why I have been saying all other things being equal, the Fed probably won’t hike this year.  Even if the answer is “no,” the Fed still may not hike this year if inflation stays low.

I would think the markets think the next Fed statement will lean slightly dovish on inflation.  I don’t think the Fed is going to say anything weak about growth, although I have been a little concerned about the economic weakness the past few months.  I don’t see any kind of recession (for now), but these are strange times.  This should be the central scenario priced in.  All other things being equal, I’m not sure if rates should move much.  So any large move could be an interesting signal on what the markets are thinking.