Are Bond Yields Too High, or Too Low?
Wage growth seems to be slowing even as employment continues to rise briskly, which is good news for inflation and growth. But the implications for interest rates are less clear.
American businesses have added about 1.4 million payroll jobs in the past six months,1 which corresponds to a yearly growth rate of nearly 2%. The U.S. economy has continued to surprise pessimists who feared that a shortage of labor would force painful tradeoffs between inflation and growth. That is great news for workers, who have more opportunities, as well as for consumers, who can enjoy the higher volumes of goods and services that additional workers are capable of producing. It is also a testament to the underlying strength of household and business spending—with a range of implications for policymakers and investors alike. Balancing out that strength with higher interest rates may be necessary.
The good news, for those worried about inflation, is that the continued increase in employment is not putting upward pressure on wage growth. In fact, the latest data imply that wage growth is slowing sharply. Some cuts of the numbers even imply that the pace of increases is now within striking distance of pre-pandemic norms, especially for the swathe of workers who are responsible for the bulk of consumer spending.
One might think that the good news over the past few months should have put some downward pressure on interest rates. After all, the Federal Reserve has raised short-term rates far above its pre-pandemic estimate of “neutral” largely in response to a modest but persistent acceleration in wage growth. That policy stance may no longer be necessary if pay increases are actually starting to normalize. And since longer-term interest rates are supposed to reflect market expectations of future short-term rates, a deceleration in wages could reasonably flow through to lower longer-term yields.
That is not what happened.
The yield on the U.S. 10-year note has rocketed upwards since this summer and is now the highest it has been since 2007. Forward interest rates are up by more than 1 percentage point, while the 2-year note yield has been essentially flat.
There are several ways to interpret this development. One possibility is that forward rates are being affected by factors other than traders’ beliefs about the level of future short-term interest rates. From this perspective, longer-term rates are now “too high”, which could be creating a buying opportunity for those willing to take some duration risk. Alternatively, forward rates are belatedly catching up to where they “should” be—and could have even further room to run.