FOMC review: The labour market is the only thing worth watching!

The inflation rate will increase markedly above 2% but the Fed considers it transitory due to bottlenecks and base-effects. The only true inflation stems from the labour market (according to the Fed), why the labour market is now the one to watch.

The Fed sounded more upbeat on economic projections (again) but also kept referring to the fact that they want to see actual progress and not forecasted progress before changing anything in the policy framework. They also need to see substantial further progress before moving towards tapering, but we are kept clearly in the dark on what that means.

Our views: Inflation risks are still tilted to the upside, 10yr Treasury yield to aim for >2% and the USD to make a comeback –> target 1.16 in EUR/USD over the medium-term.

Chart 1. Inflation expectations are currently as high as when Bernake mentioned tapering in 2013

Observations and take-aways from the statement

A generally a very neutral FOMC statement with truly little news. 120bn worth of monthly QE purchases continue, while the Fed acknowledges the progress made since the last meeting via the sentence “Amid progress on vaccinations and strong policy support, indicators of economic activity and employment have strengthened”. The Fed still looks for actual substantial progress, not forecasted substantial progress.

Else we noted that the wrote that “Inflation has risen, largely reflecting transitory factors.” Maybe this is an early first step towards admitting that inflation is stickier than anticipated？ We are grasping at straws here, probably.

Observations and take-aways from the press conference

Powell continued to refrain from specifying what‘s needed to bring about further substantial progress, but certaintly didn’t sound scared of inflation expectations overshooting target, as the Fed seems to find most, if not all, reflationary factors transitory. Powell e.g. find that the labour force is clearly negatively impacted by virus fears.

Powell: “The economy cant fully recover until people feel comfortable with gathering in crowds again and there may be people that are not willing to rejoin the labour force before they feel safe”

With significant direct transfers and anticipations of further transfers, it may be that wage costs will be driven up much earlier than in historical cycles. Could it be that workers have a better position negotiation wise against employers due to larger benefits for staying at home？ Fast food chains are reportedly struggling to get workers and are currently offering sign-on bonuses, which is something that we havent seen before in the low-skilled service sector in the US

Powell:“ It seems very unlikely that inflation expectations will significantly outpace our target without full employment.”

Chart 2. Could wage inflation show up MUCH earlier than the Fed anticipates？

The Fed is also clear that the only true inflation, is inflation stemming from a tight labour market. Bottlenecks and base-effects will not be considered when setting monetary policy. The big risk is now if the Fed underestimates the roaring comeback that employment may make over summer. If we get 2-3 months of significant labour market progress, this may test the current Fed stance. Inflation prints above 2% are not enough as they will be deemed transitory. We still consider the Fed behind the curve on this topic.

Powell: “These base effects will contribute about 1% in headline and 0.7% of core inflation. The other thing I want to talk about is bottle-necks. A bottle-neck is a temporary blockage of supply chains… We think of bottle-necks as something that will be resolved, hence they are temporary of nature”

Chart 3. Could the labour market return to strength much earlier than the Fed thinks？

Our key views: Inflation will not be transitory, rates are going up and USD could rebound

The big game-changer for inflation is that a redistribution mechanism of printed USDs has been in place for almost a year now. The direct transfers of both the Trump- and the Biden administration have broadly matched the printing-pace from the Fed, meaning that printed USDs have made it to the real-economy, in sharp contrast to QE1, QE2 and QE3 from the Fed.

Chart 4. Direct transfers is a redistribution mechanism of printed USDs, which should bring about inflation

Job openings are record hard to fill according to the NFIB survey, which could be driven by a combination of very low labor market mobility due to border closures and in turn also lucrative terms for staying at home due to higher than usual benefits. We deem that this policy mix is truly inflationary and keep seeing a risk picture tilted towards sticky inflation, in contrast to the consensus view that the inflation-spike in Q2 will prove to be transitory.

Workers are simply in a better position negotiation wise versus employers than they have been in decades. We see a risk of core inflation breaking above 3% by summer, and staying above target well in to 2022.

Chart 5. SMEs are planning to hike prices like crazy!

On rates

We are not as certain that long bond yields will continue up, as we were a month ago, but we still deem that the setback for yields has had three main drivers 1) Japanese accounts buying from the get-go of the new fiscal year, 2) fixed-to-float flow of bank bonds issued during the week and 3) oversold bond positioning that needed a light washout.

These factors are mostly temporary of nature, which could speak in favour of a return of the trend of higher long bond yields during May and June, but it will likely require either a continued complete hands-off approach from the Fed (which is very likely) or an early discussion of tapering (which would mostly move the belly of the curve). We still aim for 2% in the 10yr USD bond yield over the summer.

Our view is that tapering will be debated in June, launched in September and followed up by a subsequent hike from the Fed already in H1-2022.

On the USD

The USD has weakened materially over the past 9-12 months, which has been driven by an exorbitant money printing from the Federal Reserve not least in Q2-2020. The USD usually also weakens, when the global economy rebounds in tandem, which is what we have seen in recent quarters. The US is now about to reap the growth rewards of the experimental policy mix of massive money printing and wide scaled fiscal stimulus.

The US is likely to outperform all peers growth-wise this year, which over time usually leads to a stronger USD versus other currencies as a result of the side-effects of a stronger growth pace. First, USD bonds may continue to yield better than most peers, second the Fed is more likely to respond to strong growth rates via a slightly tighter policy, maybe via a tapering discussion already this summer.

The Fixed Income market also reflects relative growth perspectives, which simply look more upbeat in the US compared to in Europe, among other things due to a more successful vaccine roll-out. We target 1.15-1.16 in EURUSD.

Chart 6. USD-comeback to be driven by much higher growth in the US compared to peers？

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