This week the market is going towards nonfarm payrolls completely changed.
For the first time since the beginning of the Covid pandemic, the Federal Reserve has placed more importance on inflationary pressures than jobs numbers. Indeed, the central bank has started to warn about a possible tapering despite jobs have missed expectations for two months in a row showing that inflation is becoming a bigger focal point. Indeed, the central bank can afford to hold its accommodative stance only if inflation is transitory. During his testimony for Congress last Tuesday, Powell admitted that the central bank found inflation to be larger and more persistent than expected, suggesting that transitory may be longer than expected. The stakes for the debate on the transitory nature of inflation are high. If inflation is not transitory, rising prices can undermine personal purchasing power and ultimately weigh on economic growth as well as jobs.
That’s why while the doves will focus on the nonfarm payrolls, the hawks will be focusing on wage data, which are estimated to gain 3.6% year-over-year, a record in twelve years. An increase in wages underpins long-term inflationary forces that increase the money supply of consumers. At the same time, it may increase product prices as businesses have to pay for higher salaries.
On the other hand, doves will focus on jobs data that have disappointed expectations. They will highlight that weak jobs mean that the Federal Reserve may need to be accommodative for longer, putting downward pressure on US Treasury yields.
The doves' problem is that if long-term US Treasury yields fall further from where they are, it makes an early start of tapering and interest rate hikes more likely rather than less.
Let’s assume a Fed’s tapering announcement in September. An actual first taper may follow as early as October, catching the market off guards. Depending on how severe inflation is, the central bank might push forward interest rate hikes, too. Right now, 2-year US Treasury yields quote around the upper range of the Fed’s Fund target rate at 0.25%. However, Eurodollar futures are pricing interest rates at 0.5% by December next year. The divergence between the two markets shows that the front part of the yield curve may soon move higher despite the massive liquidity that continues to exist in the money market space.
The short part of the yield curve is not the only one at risk. Recently, long-term yields have been falling on the assumption that inflation is transitory. The speculation on the long part of the yield curve is that an imminent tapering would force the central bank to return to its accommodative stance shortly after a period of tightening because inflation will stabilize or even lag. This scenario falls apart if there are signs that inflation might not be transitory since the Fed will be forced to tighten for a more extended period. Thus, long term US Treasuries remain exceptionally vulnerable and even though in the short term they may fall as inflationary signs are not clear, during the second part of the year, they are likely to resume their rise towards 2%. Depending on surprises concerning tapering talks and inflationary data, 10-year yields can break above this pivotal level, accelerating the increase of real yields.
During summer, we expect 10-year yields to trade rangebound within 1.5% and 1.7% until further tapering talks. However, suppose jobs data disappoint once again this week. In that case, there is potential to see yield breaking below 1.40% and find new support at 1.2%. Yet, the downward trend will not be supported in the long term. As we progress towards more signs of permanent inflation and acceleration of tapering talks, we will most likely see yields resuming their rise.