Bond investors are growing increasingly worried about the possibility of inflation rebounding, as the U.S. labor market continues to show no signs of weakening.
The latest data from Thursday further reinforced this concern, as first-time jobless benefit claims dropped to a two-month low of 228,000 last week. In response to the report, Treasury yields for one- through 30-year bonds rose, and traders increased the likelihood of a post-July interest rate hike by the Federal Reserve before the year-end. The Treasury yield curve, which is often a reliable indicator of approaching U.S. recessions, became even more inverted.
The ongoing strength in the labor market has led to expectations that the Federal Reserve may need to continue raising interest rates. However, this scenario could potentially increase the chances of a U.S. recession, warn analysts.
Lawrence Gillum, Chief Fixed Income Strategist at LPL Financial in Charlotte, N.C., stated that his firm’s base-case view is that the U.S. is likely heading towards a mild recession towards the end of the year. On the other hand, many others in financial markets have recently expressed hope that the world’s largest economy can avoid a downturn and that inflation will decrease without a substantial rise in the unemployment rate, which stood at 3.6% as of June. Despite this, Gillum explains that “the bond market is looking at the strong labor market and the potential for continued inflation pressures.” He further adds, “The concern is that, even though inflation is heading in the right direction, it could reverse” due to robust wage gains and sustained demand.
With widespread expectations of another quarter-point increase in the Federal Reserve’s policy interest rate next Wednesday to 5.25%-5.5%, Thursday’s data raises the possibility that policymakers may adopt a “little more hawkish” stance in their post-meeting statement, according to Gillum.
The Fed’s Annual Symposium in Jackson Hole, Wyo.
The annual symposium organized by the Federal Reserve, known as the Fed, will take place in Jackson Hole, Wyoming. This event provides an opportunity for Fed Chairman Jerome Powell to reiterate a key narrative on interest rates. The goal is to maintain higher rates until inflation shows a consistent and sustainable pathway towards the desired 2% target.
Wall Street Investors Analyze the Last Mile of Inflation
Investors on Wall Street have been closely analyzing how inflation will develop in the near future. The latest update to the consumer-price index reveals a deceleration of inflation, dropping to 3% in June on an annual basis from 4% in the previous month. Although this is a significant decrease from last summer’s peak of 9.1%, it has required a series of rate hikes to reach this point.
Yield Jump Led by 3- Through 7-Year Rates
Thursday witnessed a notable jump in yields, primarily driven by 3- through 7-year rates. Fed funds traders have priced in a 31.8% chance of the Fed increasing its main interest-rate target to 5.5%-5.75% by November. This calculation includes the expected rate hike in July. Additionally, the spread between 2- and 10-year yields has widened beyond minus 100 basis points. As a result, U.S. stocks have mostly experienced a downward trend in morning trading.
Implications for the Fed and the Labor Market
Rubeela Farooqi, High Frequency Economics’ chief U.S. economist based in Jersey City, New Jersey, highlights the importance of jobless claims as they provide a timely snapshot of the labor market. Farooqi expresses the expectation for an increase in claims and rising layoffs. However, businesses have not responded accordingly, which holds significant implications for the Fed.
Farooqi further explains that the Fed wants to witness a softening in the labor market and lacks confidence in predicting future inflation trends. As a result, there is a risk that policymakers may continue raising rates until there is substantial softening in labor markets, potentially raising the risk of a recession.