Torsten Asmus
Of all the U.S. economic reports released monthly, the jobs data has become the most watched by the bond market. Greg Bonnell speaks with Alexandra Gorewicz, Portfolio Manager, Active Fixed Income at TD Asset Management, about what bond traders are seeing, and the implications for the economy.
Transcript
Greg Bonnell: Rising rates versus slowing growth. A tug of war. One of the key themes driving the markets throughout this year. Well, my next guest says for clues the key data to watch — the US jobs market. And based on its performance recently and the reaction by the bond markets, looking a little more likely the US economy may be in for a bit of a hard landing. Alex Gorewicz is Portfolio Manager Active Fixed Income at TD Asset Management. Alex, great to have you back on the show.
Alexandra Gorewicz: Thanks, Greg. Great to be here.
Greg Bonnell: So let’s talk about this push and pull that we’re seeing out there. And you’re saying take a look at the jobs market. We’re all watching inflation. We’re all watching this or that. Why is jobs so important?
Alexandra Gorewicz: It’s really going to be a guide of what the Fed does next if we’re just talking about the US market. But really any central bank is going to be paying close attention to the jobs market. So we know that for the central banks and the Fed in particular, to stop raising interest rates they’re looking at inflation. They want to see inflation fall a number of months in a row. We don’t know what that number is, but let’s say three to four months. And the level will probably also matter. But as long as we start seeing that decelerating trend in inflation, I think we could get some kind of a pause at some point. Maybe later this year. Maybe early next year.
But in terms of what the bond market is currently expecting just given the tightness in the labor market — and by tightness, I just mean everything is there isn’t very much slack. Unemployment rate is very low. Wage growth is really starting to gain momentum higher. And if we look at the last three, four months average north of 5% wage growth. And so you’re starting to see these kinds of dynamics in labor that are making bond markets nervous about how much more there could be in terms of positive news there.
And so when we think about why the bond market has two to three rate cuts priced in starting in the second half of next year for the Bank of Canada and for the Fed, it has to do with jobs. That they expect the best news are behind us. And that going forward, there will likely be an increase in unemployment and just softening overall.
Greg Bonnell: OK. That’s interesting because that’s the intersection of what they’re trying to achieve in terms of bringing inflation down by sort of tamping down our demand. A little bit worried about wages. But they keep saying it’s going to be painful. It’s going to be painful. We’re going have to endure some pain. But the fact that the bond market is saying at some point that pain is going to lead them to cut. Not that they’re going to flinch. But they’re going to realize, I guess, not only is the job done, but we’re sort of hurting out there.
Alexandra Gorewicz: Yeah. And we don’t actually know what that level will be. So if we look for some guidance from what the Fed had said back at their June meeting when they gave us their economic projections — and we won’t get updated once until their next meeting in two weeks from now. But back in June, they said, well, we think unemployment will rise to about 4.1%. And it’s now about mid 3s. So we think a marginal increase in unemployment, and that will help us bring inflation down.
And actually, we have had a number of prominent economists or former policymakers– people like former chief economist from IMF, Olivier Blanchard. People like former US Secretary Treasury, Larry Summers, saying actually there seems to be some signs of structural changes in the labor market. That could suggest that in order to bring inflation down you have to increase unemployment by a lot more than what you’re currently communicating. So the prospects of this soft landing, in other words, economic slowdown without a material rise in unemployment, probably pretty low.
And in fact, since Jackson Hole, since Powell’s speech, every consecutive Fed speech hasn’t really mentioned soft landing. So I think they’re trying to signal that a recession is likely.
Greg Bonnell: So if we can’t get soft landing, and obviously, as you’re saying, it doesn’t seem that we can achieve that given the policy aim that they have, what is a hard landing look like? Well, what does it mean for fixed income? What does it mean for investors?
Alexandra Gorewicz: Yeah. So this is the big question. So we don’t yet have insights into what kind of a recession there will be. So there are two ways of looking at this. Call it the pro and the con for the soft — not soft landing. For the normal recession case. On the one hand, inflation based on where it is today, let’s say 8% to 9%, would suggest that if you really wanted to fight inflation, you would raise the interest rates up to that level. Central banks, and the Fed, Bank of Canada, they’re not signaling that they’re going to do that. And in fact, they’ve told us they think their neutral range is somewhere between 2% to 3%. So if they raise interest rates to somewhere between 3% to 4%, they think that’s restrictive enough for the economy. But the reality is from a realized deal perspective, yields would still be negative for the economy, which means it’s not actually that painful. I mean, it should be relatively straightforward for the economy to manage. Slowdown there will be for sure. But not very material.
On the other hand, if those prominent people that are saying unemployment has to rise substantially are correct, and the Fed actually has to raise rates more than 4%, it is very possible that the economic slowdown will be much more material. And it will be a lot more prolonged than a normal recession.
Greg Bonnell: Makes me think about the dynamics powering inflation right now. And how there’s been some concerns — and TD Economics has shared them recently too — with the fact that it was one thing to have food prices, which maybe can vary depending on geopolitical conditions. Energy prices, which can vary greatly on geopolitical conditions. And we’ve seen energy come down. But then when it starts to sort of bleed over to the services side, and wages — once you get the raise, it’s pretty hard I guess for the boss to come back and say, inflation isn’t going to be a problem anymore. We’re going to take that money back. You’re like, no. Thank you very much. I think I’ll keep the raise.
Alexandra Gorewicz: Yeah. That’s right. And that’s probably what makes it so tricky here with central banks having been behind the curve up until this point. Sure, they have a better grasp on I guess the policy rates today. Mostly because bond markets have dragged them in that direction for the better part of the last 6 to 9 months. But the going forward bit is like where the tug of war happens because central banks are saying, well, we want to raise interest rates to this level and then maintain them there. And bond markets are saying, well, no because looking at how costs have built up for companies, whether it’s through wages, whether it’s through the higher commodity channel, which are input costs for corporations, it’s saying that aggregate demand, economic demand, will fall a lot more. And there’s now that bit of that tug of war between the policymakers versus market.
So in terms of what implications you had asked earlier for fixed income or for investments, unfortunately just means more volatility. But it also means that although there has been an increase in interest rates, there has been a widening of corporate bond spreads here to date, that it doesn’t necessarily mean that it’s done. And in fact, if we have a recession for corporate bonds in particular, we know that at the start of a recession, or perhaps even before the recession begins, companies, especially with good management teams, are able to manage those increased costs, whether wages or otherwise. But if the recession proves to be deeper, longer than expected, there’s only so much of the cost management that you can do. And eventually, corporate spreads widen as corporate fundamentals deteriorate. And then that exacerbates the economic slowdown.
So there’s so many unknowns at this time in terms of what the impact will be, and a big part of that will hinge on how labor dynamics will impact the type of recession we’re going to get.
Greg Bonnell: You mentioned tug of war between what policymakers are trying to achieve, or what they’re trying to signal, and what the bond market is telling us. Tug of war, a little bit of give, a little bit of push. How about a tantrum? We have seen times where then the market just decides, you know what? We don’t like what you’re doing at all. So far, we seem to be well behaved. We don’t seem to be in tantrum territory.
Alexandra Gorewicz: You know what? I guess to some extent it’s easy to see that because we look at what we call nominal yields. So nominal yields can be decomposed into real yields and then the inflation expectations that market have. So if we look at those collectively, we’ve still seen nominal rates move up quite substantially this year. But actually, the bigger story and the more important one is the change in the real yield. So I had mentioned to you, for example, on a realized basis if we take where the policy rate is, and subtract inflation, we’re actually still negative. But if that inflation — and the market expects that inflation to roll over relatively quickly over the next 12 months — if that inflation comes down, and the policy rate stays higher, you actually end up with positive real yields. And that could be really painful for the economy because you’re actually — after adjusting for your cost of living, you have to pay pretty substantially to borrow money. And our economy operates on credit.
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