A quick look at a timely topic of interest - with a brief review of why it could matter to investors.

Chart of the Week
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May 27, 2014

Good for growth? Wages up, Fed funds flat
Average hourly earnings and the federal funds rate

chart

Source: Bloomberg, as of 4/30/14. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The bottom line:

  • Economic and market indicators are decidedly mixed these days—some up, some down, others stuck in neutral.
  • Whether the economic glass is half full or half empty is unclear, but that's certainly dampened expectations that higher interest rates could be around the corner.
  • Faced with that lack of clarify, it may make good sense to focus on metrics that the Fed follows closely - in this case average hourly wages, which rose to a 2.3% year over year growth rate in April 2014 - a significant improvement over the 1.8% year over year growth level one year ago.
  • Continued moderate wage growth would signal a strengthening labor market and a gradually improving economy, allowing room for a slow, measured increase in interest rates.
  • Conversely, slowing growth in wages would reflect a loss of economic momentum—and could encourage additional Fed accommodation.
  • But consider: if the growth rate of average hourly earnings actually picks up further from here, it could signal faster economic growth than the markets are currently pricing, as well as the potential for wage-push inflation—something that has yet to be seen in the current business cycle.
  • That acceleration would most likely get the Fed's attention—it seems to have done so in the past, as the chart above indicates.

The chart:

  • The chart shows the year over year change in average hourly earnings and the Fed funds effective rate over the past 25 years.
  • Note that the past three Fed tightening cycles are closely associated with accelerating wage gains.
  • However, the acceleration in wage gains over the past year has not been accompanied by a rise in interest rates.
  • That said, the Fed's first mention of tapering last summer does correspond with the bottom for growth in average hourly earnings, and the start of that program later that year is associated with wage growth acceleration.

Context & Perspective:

  • As previously mentioned, the growth in average hourly earnings rose from 1.8% in April 2013 to 2.3% in April 2014.
  • Of particular interest: that acceleration corresponds with a 100bps increase in 10yr Treasury rates – even after the 50bps decline in 10yr yields so far this year.
  • The decline in the 10yr yield this year has been widely interpreted as a sign that the economy is faltering—even though a host of other economic and market indicators are telling another story.
  • One example: at the same time that Treasury yields have declined, credit spreads have tightened—not what you'd expect if economic conditions were deteriorating.
  • Of course, it's possible that the decline in Treasury yields is a reflection of benign developments instead of a slowdown – it could be due to possible reallocation from stocks to bonds after a big run for equities.
  • The decline could also be due to a shift in expectations about how fast economic and interest rate normalization may take—which could mean the market is now pricing a continuation of moderate growth rather than an acceleration or a downturn

Definitions:

The U.S. Federal Reserve, or "Fed," is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The federal funds (Fed funds) effective rate is based on the Federal funds target rate; it is the weighted average of the actual negotiated rates between borrowing banks and lending banks. The federal funds rate (fed funds, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.

Wage push inflation is a general increase in the cost of goods that is preceded by and results from an increase in wages.

Tapering refers to the Fed's announced approach to reduce the pace of its monthly asset purchases gradually instead of ending the purchases all at once.

A basis point (bps) is one one-hundredth of one percent (1/100% or 0.01%).

A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.


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Poll

Which Asian country will have the strongest growth in the coming year?








Poll

Which Asian country will have the strongest growth in the coming year?

Japan, as Shinzo Abe's policy initiatives take hold
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