Investors,

Below is a guest post from Caleb Franzen, senior market analyst and author of Cubic Analytics, exploring the key data driving monetary policy, yields, and asset prices. I keep hearing from investors that there’s an increased appetite for more macro commentary here, and Caleb always does a great job on his macro deep dives. Enjoy!

My goal with this publication is to highlight the Fed’s monetary policy framework in the context of recent economic data and to discuss the possible implications going forward. I’ll focus predominantly on the labor market and measures of economic activity in order to analyze the most likely path for yields. Yields are at the core of my investment framework, one that is dependent on using monetary policy as a metaphorical traffic light for risk appetite and investment decisions. The framework is simple:

Green Light: Monetary stimulus and the downward pressure on yields creates tailwinds for dollar-denominated assets to rise. In this environment, characterized by an expansion in the Federal Reserve’s balance sheet, I want to be overweight U.S. equities and risk-assets.
Yellow Light: As monetary stimulus wanes and the Fed tapers their asset purchases, yields start to rise. This signals a potential regime change, warranting a decrease in risk appetite and an allocation shift towards defensive assets.
Red Light: When the Fed starts to tighten monetary policy and raise interest rates, liquidity declines and creates headwinds for dollar-denominated assets. This phase emphasizes intense risk management, prudence, and patience.

Yields are so important because they directly impact the present value of an asset. All else being equal, yields and asset prices are inversely correlated. As proof, consider the following chart of the Ark Innovation ETF ($ARKK) vs. the inverted 10-year Treasury yield (-$TNX) since January 2021:

This chart helps to contextualize the impact that yields can have on asset prices, highlighting how an increase in yields can push tech/growth stocks lower. If we want to know how asset prices will likely perform going forward, we must attempt to understand the economic data that impacts monetary policy and yields.

The Labor Market:

The labor market provides a pulse for how the Federal Reserve’s tightening cycle is impacting their dual mandate, aiming to promote price stability and maximum employment. The labor market continues to appear strong as the economy navigates the beginning of the tightening cycle. Last week, the April Job Openings and Labor Turnover Survey (JOLTS) and the May nonfarm payroll data were released. These are the important takeaways you should know:

1. JOLTS April 2022:

6.6M hires vs. 6M total separations, of which 4.4M were quits. The quits rate remains historically elevated at 2.9% (FRED chart below), implying that the labor force is able to find better opportunities at higher pay that are more aligned with their skills and interests.
There were 1.2M layoffs in April, a rate of 0.8% which is a series low. With an ongoing scarcity of skilled labor, employers are hesitant to let go of their current workforce.
There were 11.4M job openings at the end of April, meaning that there are 1.9 job openings for every unemployed person in the United States. This remains historically elevated.

2. Nonfarm Payroll (NFP) May 2022:

Job creation of +390k vs. consensus estimates of +325k.
Unemployment rate was unchanged at 3.6%, near historical lows.
Labor force participation rate (LFPR) improved marginally from 62.2% → 62.3%. However, the prime-age labor force participation rate, measuring the participation of U.S. adults age 25-54, increased to 82.6% (FRED chart below).
Average nominal wages increased at +5.2% on a year-over-year basis, vs. +5.5% in April 2022.

The labor market appears strong on multiple levels, but it’s certainly not perfect. Personally, I’d like to see a sustained increase in the labor force participation rate; however, I find comfort in the fact that the prime-age LFPR has practically recovered to pre-Pandemic levels (83.1% in January 2020). Nominal wage growth is strong, but all gains are being depleted by higher consumer prices. As such, real wage growth is negative and consumers are having to work multiple jobs, increase their amount of hours worked, deplete their savings, and rely on consumer credit to finance their spending habits.

On the aggregate, this data highlights the Federal Reserve’s predicament of balancing the two components of their dual mandate — to promote price stability and maximum employment. In the current environment, the Fed is forced to consider tradeoffs between the labor market, which they perceive to be too tight, and historically high inflation. Bill Dudley, the former president of the Federal Reserve Bank of New York, spoke on Bloomberg last week and suggested that an unemployment rate of 4% or higher is conducive to bringing inflation back towards the 2% target. With a current unemployment rate of 3.6%, the Fed has room to weaken the labor market.

The Fed likely wants to see a fundamental shift in the labor market to confirm that inflation decreases at a sustained & material pace. If/when the labor market weakens, it’s likely that the Fed will feel empowered in their policy decisions. Conversely, if the labor market remains strong, this could put more pressure on the Fed to accelerate or increase the magnitude of monetary tightening. In this second scenario, yields are likely to rise and therefore increase market volatility.

Economic Activity:

Regarding broader economic activity, recent PMI data is flashing important signals. The ISM Services PMI released on June 1st was 55.9, but has fallen significantly from the recent peak. Optimistically, a result above 50 is still expansionary; however, the recent decline indicates that the growth rate is slowing down.

The Manufacturing PMI is still in expansionary territory as well, but has also fallen dramatically and is declining towards 50. This indicates that service and manufacturing activity are increasing at a decreasing rate. We aren’t seeing an outright contraction in either headline figure, but they are decisively trending lower.

The key findings from the manufacturing PMI were:

“Production and new orders increase at slower rates.
Cost inflation fastest since November 2021’s series peak.
Business confidence drops to lowest since October 2020”

From my perspective, the Fed is likely interpreting this slowdown as a step in the right direction as they try to engineer a soft landing. With a relatively disappointing Q1 2022 GDP print, contracting at an annualized rate of -1.4%, the PMI data above suggests that we could see softer economic data for Q2.

Conclusion:

Everything comes down to inflation and the labor market, which will directly impact the path of monetary policy and the yield environment. With insufficient proof that inflation has peaked, the Fed is likely to embark on a monetary tightening regime that will attempt to constrain consumer demand, the labor market, and overall business activity.

There will be enhanced scrutiny on the release of the May 2022 CPI report, coming on Friday, June 10. The median forecast is predicting a year-over year increase of +8.2%, slightly below the April 2022 pace of +8.3%. If the May 2022 CPI is higher than expectations, I think the Fed will become increasingly hawkish in terms of their rhetoric, forward guidance, and policy actions. In turn, this will create upward pressure on yields. Considering that yields and asset prices have an inverse relationship, all else being equal, the monetary tightening environment is likely to create more headwinds for asset prices.

Hope you all enjoyed this guest post from Caleb Franzen, senior market analyst and author of Cubic Analytics, exploring the key data driving monetary policy, yields, and asset prices.

-Pomp

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The Key Data Driving Monetary Policy, Yields…