Global Macro & Strategy

Is this THE most important chart in global macro right now ?

For the first time in a long time, inflation is the word on everyone’s lips. The latest CPI reading in the US came in at an almost 13 year high of just under 5%, and core inflation is at a 25 year high (which is the US Fed’s key metric). Since bottoming in May 2020, its been a near constant rise for year-over-year inflation numbers. In fact, since November 2020, when the COVID vaccine became reality, and pent up demand fuelled by free money handouts collided with ongoing supply side bottlenecks, its actually been a parabolic rise.

So far, markets have handled this rise in inflation fairly well. Officials at the US Federal Reserve have been going out of their way to reassure the market that these inflation pressures are “transitory”, and are mostly due to temporary supply chain issues, and that as they resolve due to the vaccine rollout, so too will these inflation pressures. Thus far, the message is being accepted. Apart from a big spike in bond yields in February this year, bond yields have since slowly drifted back down again, as has the breakeven rate recently which measures expected future inflation. Share markets have continued to grind to new all time highs, albeit the interest rate sensitive Tech sector (and Nasdaq) has gone through some major ups and downs as the market grapples with this inflation question and the resultant future of interest rates (i.e. Tech is “long duration” meaning its very rate sensitive).

Assisting this has been the fact that wages in the US have NOT gone parabolic. They have remained fairly muted, as around 7 million jobs still have not come back since pre the pandemic. But here’s the thing. Like many things in macro, there is a lag period from when one factor affects the other. And with wages its no different.

There is a strong logical correlation between tightness in the labour market, and a rise in wages. There is also a lag, whereby tightness in the labour markets is the leader, and exerts upward pressure on wages after a period of time. This lagged effect enables us to make probabilistic look throughs for the future.

Here is THE chart:

The correlation between these two is visually obvious. The blue line is a leading indicator of labour market tightness, and is suggesting there is a substantial chance here that wage growth (the orange line) moves very strongly to the upside over the next several months.

What it means for investors

Here is the key point for investors. Wage inflation is a key driver of core inflation – which in turn is at the heart of the Fed’s reaction. If wages growth starts to really crank up as suggested by this graph’s historical relationship, then core inflation will be under substantial further upside pressure, and the Fed will be in the position of having to tighten, either by way of tapering its bond purchases or actually increasing interest rates. Bond yields will in turn have enormous pressure to the upside.

That would be bad news for pretty much everything (at least in the shorter term), given how utterly dependant the entire global financial system has become on full throttle monetary stimulus, not to mention that Tech is now a big part of the US share market indices, and hence the index itself is now quite rate sensitive. The Aussie market will follow the US. And bonds wont escape either, as rising interest rates would mean capital losses for bonds.

What about the ‘slack’ of the 7 million still unemployed ?

One of the key elements of the decision of the Fed to remain so accommodative in policy even as economic data is hitting multi year highs, is the still high-ish unemployment rate and the fact that there are still around 7 million jobs that haven’t returned since the pandemic. After all, the Fed operates under a dual mandate to promote stable prices AND maximum employment. Given inflation has been a non-event for the past two decades where previous spikes have indeed been transitory, its not surprising they have been almost exclusively focussed on the latter.

This ‘slackness’ in the labour market has been constantly referred to as to why wages inflation probably wont happen. As the enhanced unemployment benefits are rolled off, people will have to return to work and this will ease wage pressures.

It’s true, that this could absolutely happen.

However, thus far there is evidence to suggest that labour supply is only marginally better in US states that have ended benefits early, compared to those that have maintained benefits. This seems to suggest that Government benefits are not the big driver they have been made out to be. Ultimately, we just don’t know how the net effect of that is going to play out. We just have to wait and watch.

The bottom line

If the historical relationship of this chart holds, then there is a clear danger of substantial US wage inflation over the next several months, which would in turn have significant flow on effects into core inflation, and we would then see just how much inflation the US Fed will really tolerate before it blinks. A tightening Fed will have significant implications for asset markets. It’s possible that workers returning to the workforce after the expiration of government benefits could offset wage inflation somewhat, but to what extent we just don’t know. We’ll have to wait and see. Either way, this is absolutely one chart that all investors should be aware of, and we’ll be following it closely over the coming months.


Author: Graham Parkes
Macro analyst & editor of The SMSF Investor

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