Clearly, last Friday’s employment report increases the likelihood that the US Federal Reserve (Fed) raises rates at its June policy meeting, or soon thereafter. With plenty of theoretical and historical support, the tightening labor market is the Fed’s chosen indicator of future inflation pressure, and Friday brought the latest in a procession of encouraging readings. Global market reactions to the employment report were uniform in their direction and ferocity. US Dollar cash rose in value versus essentially every other asset on the planet. Oil, gold, stocks (of all kinds), bonds (of all kinds), G10 currencies, EM currencies*, and most everything else fell in value on Friday. It was a bad day for the retirement portfolio, no matter what you own. Global markets realized that, rightly or wrongly, USD cash is about to pay some interest. As such, the supply/demand balance between cash and financial assets (equalized by the price of assets) got a big nudge in the direction of cash. So now what?
Well, US interest rates have moved up considerably in recent weeks, and digging into the details, something interesting is going on. In theory, Treasury yields are supposed to reflect the market’s expectation of the average short term policy rate over the life of the security, plus a fudge-factor called the term premium. For the sake of argument, I’ll assume the term premium has remained anchored and primarily the expected policy rate path has driven recent market movements. When analyzing expectations of the average policy rate over time, three things matter: 1) the timing of the Fed’s liftoff, 2) the pace at which policy rate hikes occur, and 3) where they stop hiking, i.e. the “terminal” policy rate. It turns out, when one does the math, that roughly speaking the 2-year note yield is most sensitive to the timing of first hike. The slope of the yield curve between the 2-year note and 5-year note is most sensitive to the pace of hikes. And the implied 5-year rate, 5 years forward (the “5-year-5-year” in market parlance) is most sensitive to the terminal rate. All three of these variables are observable in the market.
Few market participants doubt the Fed will eventually begin to raise policy rates, but much of the debate and discourse centers around the date of first hike. These strong employment reports should have, in theory, brought the expectation of first hike forward in time without much change to the implied pace and terminal rate. In reality, judging by our three market indicators, it looks like all the variables associated with policy tightening (liftoff, pace, and terminal rate) seem to be moving together over the past several weeks. Good data caused the market to price sooner hikes, faster hikes, and higher hikes, all at once.**
This more aggressive implied policy pathway (i.e. a higher yield curve) in the US has arrived precisely when it should be most welcomed (and supported) by foreign investors looking for a home for their investment capital. In the background, we still have negative short rates in multiple G10 currencies, and an easing policy trajectory from more than 20 global central banks across both DM and EM. Foreign investors remain saddled with ever more loss-producing cash and fewer available domestic financial assets as a result of the BOJ and ECB Quantitative Easing (QE) programs. This foreign demand for assets should be growing now at an even greater rate, as the ECB QE began just this week. The result ought to be a tailwind for asset prices, though the foreign demand needs outweigh the new Fed-induced preference for US dollar cash over assets. That likelihood is greater now that the trifecta of sooner, faster, higher pricing in the interest rate market has already cheapened financial assets vs. cash.
*Interestingly, the Russian ruble rallied, but that one is on a different planet.
**In practice, term premium increases are baked into these movements as well, but the implication is still the same.