Ever since the great recession and subsequent recovery, investors have been wondering when inflation will finally show up. One key factor contributing to still low inflation (although not the only factor) is that wage growth has been slow to materialize, even as the unemployment rate has continued to trend lower—confounding the experts. Investors may see things start to turn around now, however, with the August nonfarm payrolls report showing that average hourly earnings grew at an annualized 2.9% during the month, handily topping the 2.7% consensus estimate of economists and marking the highest growth rate since April 2009. But, does burgeoning wage growth mean that bond yields are going to move higher?
The short answer is, most likely yes. Short-term yields are most responsive to action from the Federal Reserve (Fed), which has been slowly raising rates over the last few years. The Fed has been in a situation in which unemployment has been trending lower, but without material inflation pressures bubbling up. This allowed the Fed to be slow and methodical with rate hikes, without risking runaway inflation. As inflation mounts, the urgency to raise rates could increase. We saw that within short-term interest rate markets last week, as the number of rate hikes priced into the market through the end of 2019 moved higher by nearly 0.3 rate hikes on Friday alone, the biggest one-day rise in several months. So rising inflation pressures will likely prompt Fed action, potentially moving short-term rates higher than they otherwise would have been, absent wage growth.
Similarly, increases in wage growth will likely pressure longer-term yields higher as well, as these yields are more responsive to absolute (and expected) levels of economic growth and inflation. We can see the connection between market-implied inflation levels and overall yields in the figure below, which shows that changes in investors’ inflation expectations are quickly reflected in nominal Treasury yields.
On September 7, the day the payrolls report was released, the 10-year Treasury yield rose by 7 basis points (0.07%)—its largest single-day increase in six weeks. Additionally, this was the largest pickup in the 10-year yield on a payrolls day since January 2017, indicating that markets certainly took notice of the uptick in wage growth seen in the report, and rates adjusted marginally higher as a result. If wage growth continues to trend higher, investors could expect to see longer-term yields move higher as well.
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