In the last decade, from the days of the US Credit Boom all the way to the ECB’s Quantitative Easing, Central Banks have had a controversial, yet undoubtedly crucial role in determining the fate of the wider economy and of all asset classes. Given the importance of monetary policy, is there any possible way to predict what kind of decisions Central Banks are considering for the near future? To a certain extent, the answer is positive. By being aware of the data CBs look at, and by keeping in mind the different mandates and targets in terms of inflation and employment, it is possible to predict future monetary policy, or at least know what actions markets are expecting.
More specifically, the Fed’s statutory objectives for monetary policy are maximum employment, price stability and moderate long-term interest rates. With this regard, the long-term normal rate of employment is usually considered to be around 5.2% – 5.5%, the consistent yearly rate of inflation is around 2% and we could say that the last objective is complementary with the other two. The sole mandate of the ECB, instead, is price stability, which is defined as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of just below 2%”.
Consequently, we will analyse the most important macroeconomic indicators of inflation and labour market upon which, given their mandate, the Fed and the ECB (sometimes admittedly) base their decisions. In particular, we will discuss the impact they have on the markets, and we will provide with a specific example concerning the current US labour market. Traders themselves pay close attention to the figures below, thus it is common to observe big market fluctuations or a spike in volatilities when these figures are released. Therefore, being aware of their importance is not only crucial to understand market movements ex-post, but also to hedge any trading strategy ex-ante.
Inflation
It has already been mentioned that inflation is a cornerstone for the monetary policies of the Fed and the ECB both. Although they employ their own forecasts while setting their monetary policy, actual measures of inflation and market expectations are surely crucial measures in the process. The formers are expressed by changes in the Consumer Price Index (CPI), while the latters are embedded in the 5-year, 5-year swap rate (albeit many other indicators could be used, such as breakeven inflation rates).
• Consumer Price Index: The CPI measures changes in the price level of a given basket of services or consumer goods purchased by households. The annual percentage change in CPI is useful to measure inflation. The composition of the basket used in the CPI is based on the findings of expenditure surveys carried out during the base year. It is worth highlighting that this index measures price changes from a purchaser’s perspective, and does not discriminate between persistent and transitory price changes. Therefore, the concept of underlying/core inflation has been developed to refer to the persistent component of the CPI.
Core inflation excludes the most volatile items from the index, which are usually energy and food products, and is indeed aimed at capturing more persistent price changes. The difference between headline and core inflation is especially important in the current macroeconomic environment: falling oil prices, which only impact headline inflation, imply a significant gap between the two measures.
Which inflation should we consider then? Legit question, indeed. The answer, unfortunately, is not unique. If we expect oil prices to recover in the near future, core inflation is surely the one we are looking for. However, if this shock is instead permanent in nature, it will eventually be absorbed by the other components in the index, making the headline inflation more reliable.
As inflation targets are present in most Central Banks’ mandates, these institutions closely watch the CPI and its relative changes. Actually, the Fed and the ECB employ two different price indexes to evaluate the effectiveness of their policies: respectively, the PCE (Personal Consumption Expenditures) is used for the US and the Harmonised Index of Consumer Prices (HICP) for the Euro Area. They are computed in slightly different ways, and may lead to differences in the inflation rate, albeit negligible.
To name but one example of a Central Bank looking at price indexes, on February 24th Janet Yellen noted that the PCE indicator was still tracking well below the Fed’s desired target of 2% and then that Q1.
The chart below shows the Eurozone Core Inflation Rate since 1997.
• 5y5y swap rate: In plain terms, it is the fixed rate investors are willing to pay to receive the Euribor (floating nominal rate), starting five years from now for another five years. Therefore, a decrease in this swap rate shows the market sentiment is that of a lower expected inflation in the medium term. This indicator saw a rise in popularity towards the end of August 2014, when the ECB president Mario Draghi explicitly said that “the 5-year/5-year swap rate declined by 15 basis points to just below 2% – this is the metric that we usually use for defining medium term inflation”. Later in 2014 the rate decreased even further, leading the ECB to a full version of Quantitative Easing. This indeed strengthens the explicative power of this indicator.
The chart below shows the 5y5y swap rate since the beginning of 2014.
Employment
While employment and labour market data do not play a direct role in the monetary policy of the ECB, they are crucial for the one of the Fed. Two of the most important indicators concerning the labour market in the US are released the first Friday of every month: Non-Farm Payroll (NFP) and Unemployment Rate.
• Non-farm Payroll: It represents the total number of jobs added in the US economy, not including private households, farm workers and non-profit organization employees. A strong NFP clearly indicates an expanding economic activity and is often correlated with a reduction in the unemployment rate. A similar, convers indicator is jobless claims: they are released weekly on Thursdays and state how many people have filed for unemployed benefits during the previous week. However, jobless claims are much more volatile than the NFP, thus making the NFP more impactful.
The charts below show that the NFP is positively correlated with the level of economic activity (measured by GDP growth) and negatively correlated with the unemployment rate (source: tradingeconomics).
• Unemployment rate: It is defined as the percentage of the labour force that is not employed and is actively looking for work. We will be brief on this, as it is commonly known that high unemployment is symptom of economic struggle. However, a teasing question is especially important: does a reduction in the unemployment rate always indicate an improvement of the labour market? The answer is surprisingly no. To understand why, we need to point out the subtle relationship between the unemployment rate and the participation rate, which indicates the percentage of the labour force that is employed or actively looking for work. A decrease in the former, which would indicate an improving labour market, could be simply due to a decrease in the latter, thus hiding a negative and problematic issue.
These two indicators are truly market movers, as they strongly affect the level of rates and stock index prices. Moreover, the market is now giving more and more importance to a third indicator: Hourly Wage growth. Why is that? Wages determine the level of consumptions and constitute a sizeable portion of any firm’s costs, thus having an indirect impact on core inflation and GDP growth. There could be no real recovery without a boost in salaries, especially of low skilled workers.
To be clearer, let us look at the latest US data. The US economy is posting remarkable performance. In February, the unemployment fell to 5.5% and non-farm payrolls largely beat estimates, standing at 295,000. If an investor had been only focused on unemployment and NFP she would have missed a relevant piece of information. The growth in wages was up 2% on last year’s level and the participation rate lost 10bps with respect to the previous month, standing at 62.8%.
Nowadays, labour readings and inflation indicators are a particular hot topic in the light of a possible rate hike. NFP figures and unemployment rate continue to surpass analyst estimates and the trend over the last six months has been strong. It looks like the FED has achieved its double mandate. According to a Keynesian economic view, inflationary pressures start when “full employment” is reached. And somebody states the FED should cut inflation off before it could start. Other people argue Ms. Yellen should hold rates steady until she sees a real increase in inflation. According to this view, the wage level gains even more importance as leading signal of the next possible FED’s move. Investors are especially worried about an increase in interest rates because bonds would face significant capital losses, above all if the starting place is ultra-low yields. The market has already priced in a possible rate normalization implemented in mid-2015. Obviously, any hint of an improving labour market gives further ground to the rate hike.
As a matter of fact, the outstanding data released on the last jobs Friday got the market down. The S&P500 fell by nearly 1.5%, closing at 2,071. And the bond market reacted even more. In this environment, the relationship between interest rates and prices is critical. Every bond is sensitive to rates and movements in yields affect prices according to a couple of indicators: duration and convexity. Investors control the main rates looking at the yield curve, namely a curve showing several rates across different maturities. After the release, the policy rate sensitive 2-year note saw its yield increasing by 8 bps, starting from 0.647% and reaching 0.727%. Yields on the 10-year maturity, instead, rose by 15bps and closed at 2.247%.
Interpreting data: still an easy task?
From the previous analysis, the effect of inflation indicators seems pretty straightforward: the more the inflation rate diverges from the objective of the central bank, the more this is likely to intervene. Labour market indicators, instead, usually lead to twofold conclusions. When, for instance, data signal economic strength, investors’ expectations get updated in two directions: on the one hand “real-economy” variables such as revenues and cash flows are set to be better than previously thought, on the other hand good data mean that the probability of monetary tightening increases. The same is true for the opposite case: releases that miss expectations are perceived as a guarantee of more easing by the CB, despite hurting fundamentals.
In recent years, Central Banks’ decisions have become more and more dominant in the determination of asset prices. Given the firepower deployed, the countercyclical policies of the CBs dominate the implications that economic data releases have on fundamentals. Therefore, positive data signals an increased likelihood that CBs may employ restrictive policies, thus depressing asset prices in a univocal and unambiguous way. It looks like that “good news is bad news” on the markets. Breaking inside Ms. Yellen’s mind is, indeed, more valuable than ever before.
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