Higher Is No Longer the Question, But Rather Where Interest Rates Will Peak
Bond and Equity Markets Have a Minor Meltdown
On Monday the release of the US Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS) survey caused a stir in the financial markets. Bonds sold off and equities sank as the markets choked on the news. The data were surprising in that the number of job openings was much higher than anticipated, leading punters to conclude that the labor market--long a source of inflation in this business cycle--was heating up and would boil over any second now. But looking more closely at the data, the job openings were skewed disproportionately toward white-collar business and professional services where stockpiles of labor have been hoarded since the early days of the pandemic.
This is a demand-side indicator of labor market strength, and based on its level and direction, the labor market is still quite strong. A too-strong labor market is inflationary, and higher inflation means that the Federal Reserve will have to increase interest rates to contain it. Higher interest rates increase the value of money today, so assets whose payouts lie further in the future--long duration bonds and growth stocks--go down in price. This is what happened as markets adjusted to a sudden worry over another increase in benchmark interest rates.
But every market consists of buyers and sellers. We see from this data that the demand for labor has increased, but to determine what will happen to the price of labor, we need to examine what is happening on the supply of labor side, too. Two indicators of the tightness of labor supply are the Quits Rate and the Layoffs/Discharges Rate. Their respective levels are rendered in the charts below.
The Quits Rate barely moved, indicating that workers are not voluntarily leaving their jobs. If it were higher, then that would provide additional confirmation that the labor market is growing tighter. Similarly, the Layoffs and Discharges Rate is little changed. Were it trending lower, we could reasonably suppose that the labor market was tightening.
So, while it appears that the demand for business and professional services labor has increased, the overall market for labor remains stable. And this is demonstrated further by our preferred indicator of labor market equilibrium, the ratio of Job Openings to Unemployed Persons. A ratio of greater than one indicates that sellers of Labor have more leverage in the market, while a ratio less than one indicates that buyers of Labor have more leverage. While there are still 1.5 openings for every unemployed person in the United States, the ratio is in decline, from which we can infer that the labor market, while still strong, doesn't show signs of frothiness, but rather cooling.
On Wednesday, we received further confirmation of the gentle downtrend in labor market tightness from the ADP Survey. Private payrolls increased by 89,000, compared to the prior month's far headier 180,000 increase. A figure of less than 200,000 is consistent with shrinking payrolls, and this far lower reading is somewhat ominous. These surveys are inexact and sometimes fail to agree, so more data is required to determine the direction of travel. That said, it seems far more likely that the labor market is in stasis or slow contraction rather than a fervent ferment. While we still believe that US bond yields have further to climb, and US equities much further to fall based on fundamentals, this isn't the data that will do in a historically overvalued market.
So, How High?
As we've written over the past two weeks, the bond and equity markets have been working through what the Federal Reserve means when it says "significantly higher interest rates for longer." As our longtime readers are aware, we don't believe that we know better than most others where rates will peak, nor do we believe that it is knowable. Too much depends upon sheer randomness as well as second- and third-order effects that are yet to present themselves as events of the first-order. An irreducible uncertainty lies at the heart of our enterprise, as it does at the center of our existence. That said, we don't need to know where rates will peak in order to invest well.
Short-and long-term interest rates have been climbing steadily higher as investors demand higher rates of return to compensate them for the risk of holding the obligations of the people of the United States of America. To those who invested through the global low yield environment that followed the Global Financial Crisis, a security that pays 5% yield for ten years isn't a bond, it's a dividend-paying equity. That riskless assets can return north of 5% seems like the fever dream of a modern-day Rip Van Winkle that dozed off after a particularly debaucherous game of Dutch ninepin in 2009. And yet here we are, with yields on 10-Year paper approaching a very respectable return. Of course, the fact is that it is a very normal riskless return--a return that would have seemed ordinary during the two decades preceding the GFC.
Theoretically, the real risk-free rate, denoted as r* (r star), is the hurdle rate that a rational, value-maximizing actor would demand to give up a dollar of consumption today for the return of their principal at the specified future point in time. We add the expected inflation rate to this value to obtain the nominal risk-free rate, which is what the talking heads are talking about when they talk about the interest rate. If something simpler is demanded, it is the price of money today. Expected inflation is added on top of the neutral rate of interest to compensate the investor for the value lost to inflation over the period. This is known as inflation compensation. r* has recently been very low due to a combination of known, suspected, and unknown factors.
There's a debate currently raging among academic and professional economists about what r* is, and whether it has been going up or down. It would increase for the same reasons that all assets increase: uncertainty. Where there is greater uncertainty, expected return must increase to entice the rational actor to delay consumption and invest. And the mechanism that makes this happen is a fall in price. (When talking about bond prices and bond yields, it is important to remember that they are inversely related: when one goes up, the other must go down.)
Unfortunately, the United States has been dealing with its fair share of uncertainty these past few years. It faces an increased level of domestic political risk unseen since the late sixties and early seventies. The unipolar world it inherited after the sun set on the Soviet Empire has given way to at least one more pole with its center in Beijing. The years of fiscal profligacy and the legacy of monetary expansionism necessary to deal with the COVID-19 Pandemic have blown a whole in its national Balance Sheet. Its population is graying and nearly falling below its replacement rate. And it has assumed a protectionist stance in preventing the free trade in labor necessary to prevent this demographic decline from becoming an economic one. The greatest enemy it has ever faced has no capital, never sleeps or eats, doesn't tire, and comes armed with the devastating laws of Physics in its armamentarium. Precarity abounds.
Yet, Americans are unplugging from social media, voting in higher numbers, and look set to deny a petty would-be dictator and could-be coup-plotter a second term in office. The rest of the world hasn't flocked to the Chairman Xi's banner. The country has levied higher tax rates in the face of fiscal insolvency before and came out the other side with higher productivity as well as a repaired asset/liability ratio. Its population is living healthier longer, so can work longer, especially with the aid of radical productivity-enhancing AI. The country of immigrants has recovered from anti-immigrant hysteria several times throughout its history as the oldest democracy in the world. It has taken up leadership of the free world again to lead a charge into renewable sources of energy that looks set to obsolete the century-long reign of the internal combustion engine, and the millennia-long reign of the combustion of fossil fuels. No country more resilient to existential threat has ever had its name printed across a map of earth.
In the long run, the neutral rate of interest is fixed; in the short run, it is variable. Looking out over the next five years, it must float upward to compensate for the risk and cost of disentangling global supply chains from a dependence upon China and fossil fuel. It must repay the risk of the United States being incapable of paying its debt on time. Inflation compensation must grow to reflect tighter labor markets and these other aforementioned costs. Lastly, it must increase because the rate of growth engendered by technologies like AI and other innovations yet to be will push it higher. With higher secular growth, as well as higher inflation, nominal rates of 4% look more like a floor than a ceiling; depending upon what other of these risks materialize--or fail to--it seems reasonable that rates will mean-revert to their 5 - 6% historical range. That means equities returns of 9 - 11%--and to get there requires a lot of earnings growth, or a big drop in price. But that's an article for another day.
A Brief Appeal
I started long-distance running at a very young age.* It's been a huge benefit in my life much aside from the health and discipline benefits it confers. It provided and still provides a quiet, meditative place where I used to repeat declensions and conjugations, and now work through portfolio and market problems. This year, I'm running the New York City Marathon this November to sponsor Run4Fun, a NYC-based nonprofit that provides running programming for kids after school in the NYC area--specifically for kids who have experienced trauma in their recent journey to the United States, or who come from homes affected by domestic violence. I'm running to give these kids a chance to run, too, and I'd like to ask that you join me with whatever contribution you can manage. My great thanks to all.
*I am not now, and never have been, a good runner.
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