US Rates: Rise in yields does not have too much further to go – US 10y Treasury yields have risen significantly over recent weeks. At time of writing, they were at 3.07%, up from a closing low of 2.82% on 22 August. What explains the rise and will it continue? We can break down the rise in yields into changes in the risk-free rate and changes in the term premium. The risk-free rate captures changes in expectations in the Fed’s policy rate over the coming months. Meanwhile the term premium should reflect changes in the perceived riskiness of long-term securities reflecting uncertainty around the path of inflation and monetary policy and changes in the demand-supply balance for the securities. Using data from the Federal Reserve Bank of New York model, it seems that around 60% of the rise in yields reflects changes in Fed expectations, while the rest is due to a rise in the term premium.
Changes in Fed expectations – Market-implied rate hike expectations for the Fed have increased significantly over the past two weeks. OIS forwards were pricing in just 61bp in tightening by next June as recently as 3 September, but are now pricing 79bp. With next week’s rate hike having been close to fully priced for some time already, this repricing has been concentrated in the December, March and June meetings – particularly the June meeting, which moved from being just 42% to 63% priced. This significant repricing has occurred amid a notable shift in rhetoric from prominent doves on the FOMC, particularly board member Brainard and Chicago Fed President Evans, who both suggested that it was likely to be necessary for rates to go beyond neutral estimates and to become somewhat restrictive in future. With the 2s10s yield curve having stabilised at c.25bp in the meantime, some of the concerns of more dovish members of an outright inversion are likely to be somewhat assuaged. We continue to expect the Fed to hike a further four times, taking the target range for the fed funds rate to 2.75-3.00% by next June.
Rise in the term premium – According to the NY Fed estimates, the term premium has also risen over the period. The Fed has been shrinking its balance sheet and issuance of Treasury securities has been rising to finance the administration’s fiscal package. So the demand-supply balance is deteriorating. This does not seem to be the proximate driver behind the rise in the term premium, though it played a role earlier in the year. Rather, safe haven demand for Treasuries dampened the term premium in the first few weeks of August and this effect seems to be unwinding given signs of stabilisation in emerging market assets and a more relaxed investor attitude to the US-China trade conflict.
Not much further to go – We do not think the rise in US 10y Treasury yields has too much further to run. Our end of year forecast is 3.1%. First, our scenario for the path of Fed policy rates is now not far off being priced in. Second, over the last two cycles, the 10Y Treasury yield has peaked close to the eventual peak in the fed funds rate. Third, we expect inflation to remain well-behaved. (Nick Kounis & Bill Diviney)
Euro Macro: High vacancy rates not reflected in high hourly wage growth – Eurostat has published two key reports about labour market developments in the past few days. The first is about the job vacancy rate and the second about hourly wage growth. It turns out that the vacancy rate (number of vacancies as a percentage of the total of occupied jobs plus the number of vacancies) in the eurozone as a whole came in at 2.1% in Q2, the same rate as in Q1 and up from 1.9% a year ago. It now is at its highest level since the start of the series in the middle of 2008. The division in main sectors shows that the vacancy rate is higher in the services sector (2.4%) than in industry and construction (1.9%). Looking at the individual countries, it turns out that in the vacancy rates of Belgium, Germany, the Netherlands and Austria all are well above the eurozone aggregate (ranging from 2.7 to 3.5%), suggesting that either their labour markets are tight or that there is a serious mismatch between the quality and skills of labour demand and labour supply. In any case, intuitively, wage growth should be relatively high in these countries when compared to the eurozone aggregate.
The Eurostat report about growth in hourly wage growth shows that in the eurozone as a whole, hourly labour costs increased by 2.2% yoy in Q2, up from 2.1% in Q1 and still very close to the level of a year ago (2.1%). The rise in growth was evenly distributed between wages (to 1.9% from 1.8%) and non-wage labour costs (to 2.9% from 2.8%). Paradoxically, wage growth in the four individual countries with a high vacancy rate mentioned above was not higher than the eurozone total. Indeed, hourly wage growth in Germany, Austria and Belgium was very close to the eurozone total while in the Netherlands it was even lower. Having said that, other measures of wage growth, for instance wages per employee or unit labour costs, and other measures of labour market tightness (such as the unemployment rate and the percentage of people that involuntarily work part-time instead of full-time) have tended to paint a more consistent picture of labour market slack and wage growth. (Aline Schuiling)