Bonds Commentary

Job Growth, Fed Remain in Focus

September 2021

The first week of September brought the release of the closely watched August Employment report, which showed that 235,000 jobs were created during the month, well short of the consensus estimate of 725,000. While the headline reading was not at all encouraging, prior estimates of job growth in June and July were revised higher, and the unemployment rate fell to 5.2% - bright spots not to be overlooked. Most notably for fixed income investors, in our view, was the continuation of the trend of sharp month-over-month increases in average hourly earnings. After a nearly 0.4% increase in July, this metric rose 0.6% in August, topping the consensus estimate of a 0.4% uptick, leading to louder voices from those already calling for stagflation amid weakening U.S. economic growth. We believe this to be premature.

Weaker than expected job growth in August could shift the voting balance within the Federal Open Market Committee (FOMC), as ‘doves’ recently warming to tapering the Fed’s monthly asset purchases could walk back that stance and push for a patient approach, relying on incoming data to settle the matter. The FOMC finds itself in an unenviable position. On one hand, if August payrolls had surprised to the upside or at least met the consensus estimate, the FOMC would likely believe it had the necessary cover to announce tapering at its September meeting and begin the process of reducing bond purchases in November or December. But now, with August payrolls falling short of expectations, the resolve of Committee ‘doves’ that have recently turned publicly ‘hawkish’ on tapering is set to be tested and the September meeting could turn into a “kick the can down the road” type of event.

While the August payrolls report wasn’t as weak as headlines might imply, it remains to be seen how the FOMC will interpret the release and how, if at all, it might alter the Committee’s discussions and tapering timeline. The $64,000 question(s) top-of-mind for investors in U.S. Treasuries remains when the FOMC will begin reducing bond purchases and, more importantly, at what pace. Opportunities for the Committee to telegraph its plans in a satisfactory manner and properly prepare markets for what is to come are few and far between this year if they balk at doing so at their September meeting. There is no FOMC meeting in October, and the Committee is unlikely to view mid-December as an optimal time to announce tapering plans given how sparsely trading desks will be staffed, which leaves just the November FOMC meeting. Given persistently ‘hot’ inflation data and some measure of progress on the labor front, we believe the FOMC should get on with it and announce its tapering timeline this month; however, the August job growth shortfall provides cover to be patient and we wouldn’t be at all shocked if the FOMC finds a way to punt until the Committee’s November meeting, which would still leave December as possible lift-off.

From a positioning perspective, we remain comfortable with an allocation to fixed income below our strategic long-term target. We continue to expect long-term Treasury yields to trend higher into year-end as the path forward for economic growth becomes clearer and inflationary pressures persist due to a combination of rising wages/jobs growth, and logistics bottlenecks. We continue to recommend a portfolio duration below that of our benchmark to limit interest rate sensitivity/drawdown and prefer short duration investment-grade corporate bonds relative to Treasuries. After a bout of volatility for high yield (HY) corporates in mid-August due to an economic ‘growth scare,’ the Bloomberg Barclays U.S. High Yield index was again trading at late July levels as September began. Investors appear to expect defaults to remain low for some time to come, providing them with cover to reach for yield and clip a higher coupon than can be sourced from investment-grade credit with the expectation that they can ‘buy high and sell higher’ down the road, if necessary. High yield defaults should remain near current low levels for quarters to come, but we remain neutral on the asset class relative to our long-term target allocation. Emerging market debt is appealing as a diversification tool and could benefit from rising inflation and a weaker U.S. dollar as well, but exposure must be appropriately sized.

Source: Bloomberg, Factset


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