Note: I am travelling this month. Posting will be sporadic and shorter due to limited time and equipment.
September Employment: Wow
U.S. job growth blew past expectations in September, rising by 336K compared to consensus expectations for a 170K gain. Revisions to the previous two months increased employment by an additional 119K. Not only was aggregate job growth impressively strong, but employment gains were broad-based across most industries. (…)
Source: U.S. Department of Labor and Wells Fargo Economics
A marked increase in labor supply over the past year has helped to support overall hiring. An additional 90K workers entered the labor force in September on the heels of what was already a major swell in August. The labor force participation rate was unchanged at 62.8%, continuing its now 11-month streak of avoiding a decline despite the headwinds caused by an aging population. (…)
We see scope for labor force growth to remain solid in the near-term as the still-strong jobs market pulls in workers and deteriorating finances give other workers a push. September’s moderate rise in the labor force roughly matched the increase in the household survey’s measure of employment (86K). As a result, the unemployment rate was unchanged at 3.8%.
Source: U.S. Department of Labor and Wells Fargo Economics
The more abundant supply of workers along with a less frenzied pace of hiring is helping to dampen wage pressures. Average hourly earnings came in a touch softer than expected, up 0.2% in September. On a year-ago basis, average hourly earnings have risen 4.2%—the slowest pace in more than two years—while the 3.4% annualized growth in AHE the past three months suggests a further drop in the year-over-year number is coming.
While labor cost growth still needs to subside somewhat further to be consistent with 2% inflation over time, the moderation is a welcome step in the right direction for the inflation-fighting Fed. While the typical worker may be experiencing a slower pace of wage growth, the still-solid rate of hiring suggests growth in aggregate income derived from the labor market continues on at a decent clip, which should support overall consumer spending. (…)
Source: U.S. Department of Labor and Wells Fargo Economics
We want to look at employment data from 2 different viewpoints:
- the economic growth viewpoint says the consumer is reasonably solid with labor income rising 5-6% while PCE inflation has slowed below 4% YoY. Stacked contributions to growth show that September data came in somewhat slower on a MoM basis…
…but remains comfortable on a YoY basis even though employment growth was cut by half in the last 12 months.
- the Fed-fighting-inflation viewpoint says that hourly earnings growth of 0.2% MoM in the past 2 months is below what’s needed to achieve 2% inflation.
Goldilocks? It would be best to wait a few more months, and watch the composition-adjusted Atlanta Fed Wage growth tracker which was at 5.3% YoY in August.
Now this:
John Authers: Gaza Won’t Hamper Markets — Unless Israel Strikes Iran
(…) As a general rule, outbreaks of conflict between Israel and the Palestinians in this century have had minimal impact on the oil price. (…) There is no particular reason to believe that this time will have any significant impact on the oil price — unless Israel decides that it has to draw its security boundary much wider than its current borders. (…)
Should Israel choose to involve Iran, that would be different; and any extension to involve Russia could change the world. (…)
What we should expect for now is that oil prices should rise somewhat, to recognize that risk of a major interruption to supply (caused by a war) has just increased. This should tend to put a “floor” under the price of crude, but little more than that for now. (…)
Canada’s jobs growth triples estimates in September, putting pressure on BoC ahead of rate decision Employment rose by 64,000, easily surpassing 20,000 estimate, while the unemployment rate held steady at 5.5%
(…) Employment in educational services increased by 66,000 in September, after a drop of 44,000 in August – a volatile result that economists dismissed as a statistical quirk. Part-time roles accounted for most of the employment growth last month. And total hours worked across the economy fell 0.2 per cent.
Even so, compensation is climbing at elevated rates. Average hourly wages rose 5 per cent in September on a year-over-year basis, in line with increases in July and August. (…)
The bank faces a tough call on Oct. 25, when it will make its next rate decision. It will need to consider whether recent economic figures – including an upturn in the inflation rate – are worrisome enough to justify a resumption in interest-rate hikes, which lead to increased borrowing costs throughout the economy. (…)
Wall Street Isn’t Sure It Can Handle All of Washington’s Bonds Investors long shrugged off U.S. deficits, but a torrent of Treasurys is testing the bond market.
(…) Already more than $1.76 trillion of Treasurys has been issued on a net basis through September, higher than in any full year in the past decade, excluding 2020’s pandemic surge. Official estimates show that is unlikely to decrease. (…)
The federal deficit is projected to breach $2.85 trillion by 2033, cumulatively totaling $20.2 trillion—6.1% of GDP—from 2024 to 2033, according to the Congressional Budget Office. That is well above the 3.6% annual average for the past five decades—and those estimates assume interest rates will retreat without a recession. (…)
“This year the deficit is projected to be $1.5 trillion, or about 5.8% of GDP. We have never seen a deficit like this at a time of full employment,” said David Einhorn, co-founder and president of hedge fund Greenlight Capital, at Grant’s investment conference this past week. “I think everyone agrees that it’s unsustainable. But not everyone agrees when it becomes a problem.” (…)
The Fed financed much of the fiscal measures since 2008, but now it is paring its $7.3 trillion balance sheet. America’s largest foreign creditor, Japan, cut its U.S. bondholdings to their lowest since 2019 earlier this year. Big banks’ Treasury purchases are constrained by regulatory requirements.
“The Bank of Japan has definitely contributed to the rise in U.S. yields,” said Tim Ng, a portfolio manager focused on U.S. debt and interest rates at Capital Group, a $2.3 trillion fixed-income asset manager. “Japanese investors looked for yield in the U.S. and European bond markets—now Japanese government bonds look more attractive. It’s a meaningful shift.”
The Japanese 10-year government bond yield recently climbed above 0.80 percentage point, more than double levels from June. Higher yields have also fueled a stronger dollar, making it more expensive for Japan-based investors to protect their holdings from currency fluctuations. (…)
The U.S. bond market is on track for its third consecutive year of losses, something that has never happened before. While investors holding high-quality debt can still expect their coupon payments and full principal at the time of maturity, that has dealt a blow to anyone heavily invested in supposedly ultrasafe Treasurys. (…)
Ed Yardeni:
September’s deficit (Thu) is likely to show that it totaled $2.0 trillion during fiscal-year 2023, which ends in September. Excluding the pandemic years, that would be the widest fiscal-year deficit on record. And that’s even though the economy has been growing.
The biggest problem with this big problem is that Washington’s net interest outlays rose to $633.7 billion over the past 12 months through August. It’s doubled since July 2018.
The average interest rate on the government’s huge debt was 2.50%. The 2-year Treasury yield is over 5.00%. So this outlay will continue to grow faster than all the other major outlays and continue to widen the deficit in fiscal-year 2024.
- It Doesn’t Have To End Badly. (Ed Yardeni)
So far, the Treasury bond yield has essentially normalized to the yield levels of 4.00% to 5.00% that prevailed from 2003 to 2007, before the “New Abnormal”. That was the period from the Great Financial Crisis through the Great Virus Crisis, when the major central banks worried about deflation and obsessed about raising the inflation rate up to their 2.0% targets. During that period, interest rates were abnormally low and quantitative ease proliferated.
So far, the economy has proven remarkably resilient in the face of the three-year jump in the bond yield from a record low of 0.52% on August 4, 2020 to almost 4.80% currently. This raises the possibility that the economy can live with the bond yield back to its old normal level.
Then again, the velocity of the rate backup has been head-spinning, as it took only three years to fully reverse the decline in the bond yield during the 12 years of the New Abnormal. Depressing lagged effects on the economy are likely still to emerge. However, they might continue to play out as a rolling recession rather than an economy-wide recession. The rolling recession is currently rolling into the commercial real estate market.
What would it take to stop the Treasury bond yield from climbing well above 5.00% other than a deflationary debt debacle? Possibly the “immaculate disinflation” we expect. That is, we think inflation can continue to fall without an economy-wide recession.
We also expect to see a slowdown from Q3’s consumer-led boomlet, with real GDP rising to between 4.0% and 5.0%. We think that Q4 real GDP growth will be back down to 2.0%. In this scenario, demand for Treasuries should absorb the supply with the yield south of 5.00%.
Be warned: If we see the yield soaring well above 5.00%, we (along with everyone else) will have to conclude that Dalio’s debt crisis might have started.
The red dash line is set at 2.0%. If the Fed gets inflation to 3.0%, the current real yield = 1.8%. At 2.5% inflation, real yield = 2.3%. FYI.
(…) The real issue is rising government outlays, with two types standing out: (i) public pension and health care spending and (ii) interest expenses. With bond yields pushing higher, the second factor is worsening by the day.
As is well known by now, an aging population will increase outlays for Social Security and major health care programs, from 10.9% of GDP this year to 12.6% of GDP in 2033, according to the latest projections from the Congressional Budget Office. However, with other types of government spending projected (but not guaranteed) to be restrained, the primary balance (excluding interest costs) is expected to be stable at around -3% of GDP for the next decade, give or take 60bp in any given year. That is nothing to be proud of, especially at a time when unemployment is near record lows.
Add in rising interest costs, however, and the overall fiscal outlook becomes downright worrying. Louis has warned of this for a while (see The Three Prices: An Update On US Treasury Yields), but his concerns have not been a major worry for the broader market. Indeed, the US’s total budget deficit (including interest) is projected to run at almost double the primary deficit for the coming years, or around -6% of GDP from today through 2030. It is then projected to blow out to more than -7% by 2033.
A decade from now, interest expenses are projected to total 3.7% of GDP, exceeding “discretionary” spending on defense (2.8%) and non-defense programs (3.2%). (…) The real point is that interest costs are becoming one of the biggest components of government outlays, as shown in the chart on the prior page.
Such large and sustained deficits mean that debt will accumulate rapidly, with the CBO projecting a rise in the US’s debt-to-GDP ratio from about 100% today to almost 120% in 10 years time. More worryingly, the CBO made these projections in May, when bond yields were some 100bp lower. If yields hold up, or rise further, the next set of projections will be even worse.
What happens when r > g?
The rise in bond yields is concerning given that it has coincided with a decline in nominal growth rates. When interest rates (r) are above the nominal growth rate (g), interest costs rise relative to GDP. And if that interest is financed with additional debt, interest alone will increase the debt-to-GDP ratio, even if the primary budget is balanced. Add in a primary budget deficit, and the outlook gets worse still. Absent a change of policy, on current trends for interest rates and nominal growth such a “debt trap” dynamic seems set to play out.This situation marks a change of circumstances, since most of the pandemic period saw low interest rates and high nominal GDP growth (r < g). Budget deficits blew out due to large-scale primary deficit spending, even as benign interest rate dynamics kept the debt sustainable. In recent months, however, nominal GDP growth has slowed while yields have risen, such that rates now exceed nominal growth (r > g). (Five-year treasury yields are used in the chart overleaf because the average maturity of outstanding treasuries has ranged from 4-6 years since the 1990s).
Actual interest rates paid by the US government will rise gradually as it issues new debt to refinance maturing debt, pay interest on existing debt, and finance ongoing primary deficits. But it won’t be too gradual given the scale of primary deficits ahead, the fact that the average maturity on existing debt is not that long, and given significant exposure to short-term rates (…).
The bottom line is that while there is a lag, rising market rates will eventually translate into higher interest rates paid on government debt—as is already starting to happen (see chart below). And that will raise more questions about the sustainability of US debt.
The US’s fiscal outlook will vary if the recent trend of rising nominal interest rates and slowing nominal growth continues apace. Consider three scenarios:
- r > g: interest rates continue to rise, while nominal growth continues to slow, widening the gap between r and g. In this scenario, interest costs per unit of GDP will rise sharply. In turn, this makes the already worrying outlook for deficits and debt, relative to GDP, much worse.
- r = g: it is possible that what the chart on the prior page shows is both a normalization and convergence of interest rates and also nominal growth. Having normalized, both variables could now fluctuate around similar rates—as has been the case historically. This dynamic is not as favorable to public finances as that of the past few years (when r < g), but it is better than scenario #1. In such a case, the debt-to-GDP ratio will still rise—assuming primary deficit spending continues—but the link between r and g will not make it worse.
- r < g: this amounts to a reversal in one or both of the recent trends, with interest rates rolling over and/or nominal growth rebounding. This would be a return to the dynamics of recent years and a welcome development for fans of government spending. While that does not include me, the former chief economist of the International Monetary Fund, Olivier Blanchard, is betting on this scenario. He thinks “secular stagnation” will soon return, characterized by low rates of nominal growth but even lower nominal interest rates (so r < g). If so, the fiscal outlook, in terms of debt-to-GDP, will at least marginally improve, even without any improvements to the primary balance.
Whatever scenario unfolds, the fiscal outlook will be poor due to ongoing primary deficits. But interest rates will put more pressure on the government to act, should scenario #1—or even scenario #2—prevail.
What can the US government do?
With debt funding becoming increasingly costly, how will the US government respond, if at all? There are a few options:
- Raise taxes? While the government may try to raise tax rates—e.g., on the wealthy or on corporations—this may not boost revenues. After all, despite US tax rates being adjusted many times over the years (with thousands of pages added to the code), US tax revenue has since the 1960s varied within a stable range of 15-20% of GDP.
- Cut spending? This could occur by reforming Social Security or health care programs. It could come from cost-saving technological breakthroughs (e.g., in health care). Or it could take the form of cuts to discretionary spending, in defense or non-defense categories. Quite likely, some combination of all such spending cuts will eventually be required. However, given the political obstacles to cutting spending aggressively, this is likely to be only part of the solution.
- Force regulated entities to buy more Treasury debt? The government is already doing this. Indeed, after three of the largest bank failures in US history earlier this year, the government did not let a good crisis go to waste. It quickly got to work raising capital requirements, which amounts to forcing banks to hold more “risk-free” treasury securities. Justified or not, it is convenient. This is also likely to be part of the solution.
- Rely on the Fed to monetize the debt? This is more limited in scope than is generally perceived—at least given current economic and financial conditions and the Fed’s existing monetary policy framework. However, conditions change and so can policy frameworks.
Fading Optimism on Rates Signals Trouble Ahead for $425 Billion Debt Wall
(…) Two data points that highlight the extent of corporate trouble: companies have about $425 billion of dollar-denominated junk debt due to mature before the end of 2025, and market yields for speculative-grade bonds are now at least 3 percentage points higher than the average coupon the borrowers are paying on their existing debt. (…)
“The junk bond market needs to massively reprice to account for refinancing risk with benchmark borrowing rates so high,” said Althea Spinozzi, a strategist at Danish lender Saxo Bank. “I can’t see how the default rate doesn’t rise sharply and there will be stretched balance sheets everywhere.”
That kind of thinking helped lift the average yield on the Bloomberg Global High Yield index to 9.26% this week, the highest since November last year and nearly double what it was at the start of 2022. The drought in new sales followed more than $23 billion in issuance in September, the busiest month since January 2022. (…)
Debt-laden companies across Europe, Middle East and Africa face a $500 billion refinancing scramble in the first half of 2024, a challenge that could kill off many “zombie” businesses even though an expected peak in rates could bring some relief.
Businesses facing rising debt costs after years of low rates will have to compete to secure enough cash in the biggest corporate refinancing rush seen for years, just as banks rein in risk ahead of stricter capital rules.
Analysis by restructuring consultancy Alvarez & Marsal (A&M), shared with Reuters, shows the value of company loans and bonds maturing in the six-month period is higher than any other equivalent period between now and the end of 2025.
A crunch is looming, finance industry experts said, with many weaker, smaller businesses seeking new private loans and public debt deals just as government borrowing costs – which influence loan rates – are soaring globally. (…)
Reuters Graphics
The latest official data from Britain’s Office of National Statistics put corporate insolvencies in England and Wales at 2,308 in August, up 19% on the previous year.
Begbies Traynor’s quarterly Red Flag Report on corporate distress, covering the April-June period, found that 438,702 businesses across the UK were in “significant” distress, up 8.5% on a year earlier. (…)
The Bank of England has urged lenders not to underestimate the risk of corporate loan defaults and to avoid relying on models that measure risk across entire sectors rather than individual borrowers, after England and Wales had the highest number of company insolvencies since 2009 in the second quarter.
One major bank is referring 100 small businesses a month to its restructuring team, up tenfold from 18 months ago, Paul Kirkbright, a managing director in A&M’s restructuring practice, said. He declined to name the bank.
One senior banker told Reuters their bank has plans to redeploy hundreds of staff to support distressed business customers if high funding costs and flagging consumer demand push more companies to the brink.
But so far business borrowers have shown few material signs of stress, two senior banking sources told Reuters.
This resilience is partly due to liquidity pumped into the economy during the pandemic but banks’ year-end asset quality reviews – which measure a loan’s underlying strength – will be key, Kirkbright said.
Eva Shang, co-founder and CEO of Legalist, a U.S.-based hedge fund that offers debtor-in-possession (DIP) financing to companies in Chapter 11 bankruptcy, told Reuters her firm had received more than 300 applications for funding since January, mostly from Main Street businesses in distress due to rising interest rates and the end of COVID stimulus.
Tougher capital rules for banks that come in from 2025 are expected to constrain appetite to support companies in need of fresh funding, industry experts said.
Katie Murray, CFO at NatWest Group (NWG.L) told a conference last month that her bank had concerns about how Basel III capital rules might impact small business lending.
Some lenders have tightened credit terms and even offloaded some smaller business customers entirely as they review the profitability of those relationships, said Naresh Aggarwal, policy director of the Association of Corporate Treasurers. He pointed to construction and retail sectors where he felt strains were most acute. (…)
Profit Warnings to Hit S&P 500 as High Rates Pinch Consumers S&P 500 to slump on earnings results, majority of respondents in Bloomberg survey say.
Concerned that Americans might be pulling back, 80% of 567 respondents in the Bloomberg Markets Live Pulse survey said that some sectors are likely to caution about earning trends when they report quarterly results. This will weaken the S&P 500 Index, which gained 1.2% Friday after a breakthrough in talks between unions and automakers lifted sentiment. (…)
Investors are concerned that higher interest rates will start seriously weighing on the economy and eat into profits that are just starting to recover from the steepest slump since the pandemic. (…)
On top of the risk from elevated borrowing costs and a weaker consumer, earnings expectations for S&P 500 companies over the next 12 months are near record highs. About 60% of participants see the upcoming results pushing the S&P 500 lower. Nearly 37% expect the gauge to end the year 5% to 10% lower from current levels, and 8% see it sliding even more. (…)
Yet, for all the headwinds, more than 40% expect this season to show how resilient the economy has been. The first test of that sentiment will be when JPMorgan Chase & Co. kicks off the earnings season in earnest on Oct. 13 and peers follow as banks provide a glimpse into the health of the economy. (…)
FYI:
