As currency investors we look for macro discrimination to underpin our views and while subdued inflation and low bond yields have been key common features across major economies in the current growth recovery, the divergence in labour market dynamics has been striking. Whereas the rise in Euro area unemployment has barely been dented, the fall in US or UK unemployment has been faster than anticipated.
Yet the Fed’s view of the labour market may be conflicting with that of investors looking for differentiation for longer than in past cycles. As Fed Chair Yellen will likely emphasise at Jackson Hole this week, the Fed’s judgement is that labour market slack is wider than what traditional indicators might indicate, such as the unemployment rate. The fact that wage inflation has so far failed to pick up despite what looks to be a tightening in the labour market lends support to the Fed’s view. Yellen has indicated that a 3-4% yearly rise in wages would be needed.
We believe that the Fed is unlikely to signal any shift in policy stance before the December FOMC meeting, as subdued inflation and wages allow the Fed to be patient. However by the turn of the year, we expect evidence that US cyclical recovery is gaining traction and that an acceleration in wage inflation lies ahead to lead to a re-pricing of Fed policy by markets. To illustrate this view, we show in chart 1 a z-score measure of 12 labour market indicators, including the ones that Yellen has been focused on, and this rough proxy of labour market slack is now closing based on historical trends. In particular, the recent improvement in hiring intentions in the NFIB survey and the strong rise in job openings have played for a reduction in our slack measure over the past couple of months. This chart suggests to us that wage inflation will pick-up, with a lag, however, it is still a long way before wage inflation reaches 3-4% YoY.
Chart 1: Wage inflation lagging compared to our labour market slack indicator
Sources: Haver, Bloomberg, BLS, Millennium Global. Data as of 19 August 2014.
The Fed is likely to wait longer for the first hike as it attempts to repair the supply side of the economy (e.g. boost the employment ratio), with the associated risk that it may then have to hike faster than currently expected as signs of inflation emerge. Fed policy may in that way avert a further downgrade in potential growth compared to pre-crisis. In turn, better sovereign and corporate balance sheets and higher potential growth in the US compared to the Euro area are ultimately the key driving factors behind our bullish view on USD vs. EUR over the medium term, in addition to monetary policy differentiation.