December Jobs Data and Defensive Fixed Income Positioning amid Lurking Inflation Risks


January 13, 2017 [U.S. Jobs, Inflation Risks, rising rates]
Josh Yafa

In the latest jobs data, fixed income investors should scrutinize the labor participation rate and wage growth to help inform their positioning, given interest rate risk.

The December U.S. jobs report wasn’t particularly surprising, though a couple of nuances are worth considering for fixed income investors. While the economy added 156,000 jobs, which was a bit below consensus, and unemployment ticked up to 4.7% from 4.6%, labor force participation of 62.7% remains at near four-decade lows. On top of the workers that left the labor force during the financial crisis due to structural unemployment, some 10,000 baby boomers continue to retire every day.

Wage growth, too, stands out. Salaries rose 2.9% year-over-year in December, continuing an uptrend. All things being equal, low unemployment would typically lead to wage growth as employers fight for employee talent. That normally creates an inflationary impulse that causes the U.S. Federal Reserve to sit up and take notice.

Market inflation expectations continue to reflect a mix of inputs in the wake of the November election results. The break even inflation rate, which is measured in the difference between 10-year TIPS (Treasury Inflation-Indexed Constant Maturity Securities) and 10-year nominal U.S. Treasuries, sits around 2%. That’s the implied average annual inflation rate over the next 10 years, effectively matching the Fed’s 2% inflation target. The Fed, though, relies on the core Personal Consumption Expenditure price index (PCE), which excludes more volatile food and energy prices and last measured 1.6%, not on the 10-year break even inflation rate. So, while core PCE isn’t technically hitting the Fed’s target, it’s pretty close. The possibility exists that declining work force participation is currently masking inflationary forces. In the future, however, declining numbers in the labor pool could lead to wage pressures.

Inflation, of course, is a risk to fixed income portfolios. Not a definite outcome, but a possibility that requires appropriate compensation. Portfolio managers must balance risks across multiple outcomes. Needless to say, interest rate risk remains elevated and thus we will consistently seek proper reward for the duration risk of longer-dated maturities. Frankly, the same also goes for credit risk. Spread compensation has been declining even though risk-free rates have been increasing, meaning corporate all-in-yields are presently roughly in-line with where they were pre-election (some lower, some higher).

Add all of this up and it means we continue to be defensive – favoring relatively low duration, high credit quality, and high cash balance positioning.

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