On Cinco De Mayo, We Look Back at April
The Tells of April About to Appear
This week is filled with three reports that will quickly define the economic activity in April: the ISM Manufacturing, ISM Services, and BLS Employment Report. The ISM Manufacturing ostensibly disappointed but it was due solely to supply constraints. Large backlogs and scant inventory point to robust orders but a lack of parts to complete production. Expect that to rectify itself in the months ahead. ISM Services is due later this morning and is expected to be another record-breaking number. The jobs report Friday is expected to be stellar as well with close to a million jobs created which will bring the unemployed total down around 7.4 million. That’s still a lot of unemployed but the trends couldn’t be better. Treasury Secretary Janet Yellen clarified remarks yesterday that initially spooked markets by implying rate hikes could happen if the economy appears to be overheating. In her clarification, she stressed Fed independence in the course of setting monetary policy. We remember that December 2015 rate hike by the Yellen Fed that was a year too early. Guess old habits are hard to break. Finally, in our latest podcast, Erik and Caleb discuss the 3 common mistakes they see banks making in their marketing, and what to do about it! The iTunes link can be found here and the Spotify here.
Fed Eyes Wage Growth for Inflation Cues
When it comes to its dual mandates of full employment and cost stability the Fed is clearly focused right now on getting the 8.4 million still unemployed from the pandemic back to work. That much is clear. They are willing to incur a period of above-trend inflation in order to make that happen. But what exactly are they focused on in the inflation mandate so we can better understand their reaction function? First, they have made it clear they don’t consider the upcoming spikes in inflation to be of concern. Short-term moves in costs due to supply constraints and the math of base effects does not concern them. Those are temporary moves that don’t have the staying power that requires Fed intervention. The key to the Fed on the inflation mandate is demand-side inflation brought about by rising wages that fill consumer wallets and then get spent on goods and services driving demand and prices up on a more durable basis. The graph below tracks the Employment Cost Index which looks at compensation and benefit costs for employers on a quarterly basis. As shown, employment costs were stubbornly below 3.0% prior to the recession but that’s better than the 1.5% rate coming out of the financial crisis recession and the long slow climb back towards 3.0%. If you want a reason why inflation has trended below 2.0% in the last decade this graph is a good illustration of why.
The Fed would like to see ECI rates that prevailed prior to the financial crisis of 3.5% to 4.0% to get inflation smartly over 2.0% on a sustained basis. Is that possible? We shall see in the months ahead. One thing that may help is the supplementary unemployment benefit of $300/week has forced employers to up wages for the lowest of positions in order to fill them and that may flow through in a jump to the ECI. But will it last? The supplementary benefit expires in September and as such the Fed may wave-off any near-term wage increase as temporary, just like the supply and base effect forces. Thus, we think Fed policy remains ultra-accommodative even if wage gains show a nice pop in the summer months. Any back-up in Treasury yields as a consequence may be a nice time to buy.
ISM Manufacturing Backlog/Low Inventory Points to Continued Strength
The latest ISM Manufacturing Index for April disappointed by some measure on the headline, hitting just 60.7 versus 65.0 expected and 64.7 in March. That “miss” led to a rally in Treasuries on Monday but the disappointment was really over lack of supplies to complete orders than it was a drop in the orders themselves. As the graph below shows, order backlogs rose to a new high for the series and inventories fell to a new low. Supply-chain disruptions are having a real impact on production but the goods news is that those disruptions should eventually fade as re-openings continue across the country and, hopefully, the globe and those backlogged orders will eventually be filled.
Rather than be a bond-bullish report it should have been a signal that manufacturing strength continues to be solid, and when paired with a quickly rebounding services sector, second quarter GDP should be equal to or better than what we saw in the first quarter. Presently, the Bloomberg Consensus has second quarter GDP at 8.1% while the Atlanta Fed’s GDPNow Model is sporting a nifty 13.175% projection. That may be a bit too optimistic but a double-digit second quarter GDP is a real possibility. Yet, bond yields remain unmoved, for now. The ISM Services Index for April will be released later this morning and is expected to print a second monthly all-time high reading as the spreading vaccinations and re-opening trends are moving quickly into the last segments of the economy yet to recover: the restaurant/bar, hospitality, and business/leisure travel businesses. Maybe those optimistic GDP forecasts have it just about right?
Agency Indications — FNMA / FHLMC Callable Rates
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