- In light of high inflation and aggressive central bank measures to fight it, we have a cautious outlook for fixed income markets.
- Volatility may continue given expected further tightening of monetary policy, higher interest rates, and less liquidity in the marketplace.
- We prefer to maintain a lower level of risk in this environment but selectively pursue attractive opportunities such as structured credit, where many assets remain on solid footing and some continue to improve.
A wage-price spiral makes the Fed more hawkish
Fixed income markets experienced widespread declines in the U.S. and globally in the third quarter of 2022, as inflation remained high and became more broad-based. While shortages of commodities and goods might have started the inflationary trend, an excessive and misplaced stimulus has made tight labor markets the driver of inflation.
The post-Covid-pandemic supply of labor has been limited, making it challenging for businesses to fill job openings. The Fed knows that demand for labor needs to come down and is closely watching job openings data. When the labor market is tight, quits rise and job openings last longer. This positive association between quits and openings has prevailed over time. Businesses may react to higher staff turnover by increasing job openings disproportionately, perhaps acting on a precautionary motive. Demand has been so strong that businesses have been willing to pay more to find and retain employees. Since households have been willing to continue spending, firms have pricing power.
The combination of a limited labor supply and firms' willingness to offer higher wages amid high staff turnover appears to have touched off a wage-price spiral. Large job openings are a manifestation of this. The Fed and other central banks seem to be aware of the problem and are ready to break this cycle by tightening rates more than anyone, including themselves, had expected. They are once again the only game in town, as fiscal policy is not contracting.
Europe's challenge goes beyond energy
Europe's severe energy crisis prompted policy intervention. It also seems to have caused a common misconception that commodity prices are driving Europe's inflation. In fact, the region's central bankers are also waking up to tight labor markets.
The severity of the pandemic and the associated policy response were similar in the U.S. and Europe. Although the U.S. discretionary fiscal impulse was stronger, Europe had larger automatic stabilizers. Fewer Europeans lost jobs as retention programs were swiftly put into place and remained effective a long way into the recovery. When the employee retention schemes started to wind down, policymakers were at first nervous of job losses, only to be surprised as labor markets kept tightening.
The euro area unemployment rate, currently at 6.6%, is well below the pre-pandemic low of 7.5%. While it might look high compared to the U.S. rate of 3.5%, Europe's labor participation rate is consistently higher (83% in the euro area vs. 62% in the U.S.), because there is a benefit from staying in the labor market. As long as you claim you are looking for a job, you can continue to collect unemployment benefits. Labor unions are also more prevalent in the euro area and have more to say on wage increases. The negotiated wage inflation went up this year to 2.4%, versus the pre-pandemic average of around 1.7%.
Fiscal policymakers, too, are making their own contribution to wage inflation. European governments have been raising minimum wages to relieve the cost-of-living pressures. If fiscal policy does not become too accommodative and the labor market begins to deteriorate, the European Central Bank might pause after seeing declining inflationary pressures. We are not there yet, especially now that another job retention program idea is circulating in Europe. Until the labor market notably weakens, the ECB is likely to keep hiking. The ECB may not have to hike as much as the Fed does, but since the seeds of inflation have already been sown, it may not turn accommodative quickly, either.
The Treasury yield curve inverted as inflation persisted and the Fed confirmed hawkishness
Source: U.S. Treasury Department. Past performance is not indicative of future results.
The Bank of England must tighten policy
In the U.K., the unemployment rate of 3.6% is now below the pre-pandemic lows and close to lows of the early 1970s. However, total employment is yet to recover to pre-pandemic levels, in contrast to the U.S. and euro area. This is due to the changing hiring patterns for part-time work, as full-time employment is now above the pre-pandemic levels. The working age population seems to have stagnated. It is possible Brexit's impact on immigration has been enhanced during the pandemic, limiting the overall labor supply.
The U.K. employment report classifies the reasons people give for not being in the labor force. The reason "looking after family" had been in structural decline, but reversed direction in 2021. This group consists mostly of women, who may continue to enter the labor force in greater numbers. While this could bring some improvement in participation, it would not be much. On the supply side, the labor market looks tight.
On the demand side, U.K. job openings are high. The average vacancy rate before the pandemic was 2.3%, and now it is 4.2%. The pace of average weekly earnings increases has also accelerated since late 2020 and is still high at a 5.5% annualized rate. Compared to the euro area, the U.K.'s labor market is more flexible and job turnover tends to be higher. With higher job turnover, the underlying tightness shows up in wage inflation quickly.
For inflation to normalize back to pre-pandemic levels, the tightness in the labor market needs to ease. For the U.K. as well as the euro area, the looming gas crisis can reduce demand for labor, but fiscal measures aiming to alleviate the pressure on households and businesses will be working in the opposite direction. The BoE will have to hike more and maintain the policy tighter for longer to bring the demand for labor back to pre-pandemic inflation dynamics.
It's the labor market now
The catalysts starting the inflationary period might vary — from a surge in energy or food prices to a significant depreciation in currency or a loss of confidence in government — but once it starts, it is the tightness in labor markets, especially when there is no fiscal discipline, that extends the inflationary process.
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Fixed income markets experienced widespread declines in the U.S. and globally in the third quarter of 2022, as inflation remained high and became more broad-based.