How Bond Traders Made Millions on 1-Cent Rise in U.S. Wages
Jason Evans knew he had to act fast.
It was 8:30 in the morning on Aug. 1, which meant the U.S. Labor Department’s monthly wage data had just been released.
One day earlier, the 46-year-old co-founder of NineAlpha Capital LP, a hedge fund specializing in U.S. government debt, detected signs of bearishness in the bond market after a report showed employment costs rose by the most since 2008.
Yields on 10-year Treasuries hit a three-week high, suggesting traders were bracing for evidence the long-awaited pickup in wages would materialize and provide the catalyst for the Federal Reserve to raise interest rates -- a view that Evans determined was wrong. So when his computer screen showed hourly earnings were unchanged in July, he knew exactly what to do: direct his traders to buy more Treasuries.
“We were at the edge of our seats,” Evans, the former head of U.S. government bond trading at Deutsche Bank AG (DBK) and Goldman Sachs Group Inc., said in a telephone interview from his 17th floor office in downtown Manhattan.
Treasuries rallied that day, causing yields to retreat from their earlier highs. Since then, they have fallen even further as crises in Russia and the Middle East prompted investors to pour into haven assets. Yields on benchmark 10-year notes dropped as low as 2.35 percent last week, the least since June 2013, and ended at 2.42 percent. The yield was unchanged as of 11:55 a.m. today in New York.
While the economy rebounded last quarter from the steepest drop-off in five years and employers added jobs at a pace not seen since 1997, the lack of wage growth and any resulting inflation has become one of the biggest reasons why bulls in the $12.2 trillion market for Treasuries (USGG10YR) have gotten it right.
The 139 million workers that held non-farm jobs in July made an average $24.45 an hour, just a penny more than in the prior month, government data show. It was the third time in five months that wages rose less than economists’ estimates.
On an annual basis, growth in hourly earnings in the past five years has been the weakest over the course of any expansion since at least the 1960s, data compiled by Bloomberg show.
It wasn’t supposed to be this way. At the start of the year, Wall Street prognosticators foresaw 10-year yields rising for a second year and reaching 3.44 percent by year-end. They anticipated a strengthening U.S. economy would lead to a pick-up in consumer prices and enable the Fed to start raising rates, which it has held close to zero since 2008.
Without higher wages, there’s little chance that Americans will spend enough to cause inflation to accelerate. Since 2009, the U.S. consumer price index has risen less than 2 percent on average and bond traders anticipate about the same rate of cost-of-living increases during the next five years.
Based on the Fed’s preferred measure, consumer prices have climbed less than its 2 percent target for 26 straight months.
“You cannot have sustainable CPI inflation without wage inflation first,” David Tan, global head of rates at J.P. Morgan Asset Management, which oversees $1.7 trillion, said in an Aug. 6 interview from London. That’s one reason why “Treasuries will remain in demand by people like ourselves.”
Tan, who said he was tempted to bet against Treasuries, reconsidered on the basis of slow wage growth.
Lackluster earnings growth also raises the likelihood Fed Chair Janet Yellen, who has increasingly focused on wages to gauge the health of the world’s largest economy, will maintain the central bank’s easy-money policies into a sixth year.
Traders have already scaled back their expectations for the Fed’s first rate increase since 2006. There’s now a 54 percent chance the Fed will lift its target rate to 0.5 percent by July, futures trading shows. On July 31, it was 65 percent.
“We’re buying into the view inflation won’t be a problem and that there is continuing scope for the Fed to exercise patience,” Wan-Chong Kung, a Minneapolis-based money manager at Nuveen Asset Management, which oversees more than $100 billion, said by telephone on Aug. 4.
The longest-dated Treasuries, the most sensitive to losses as inflation picks up, suggest many investors share her view.
U.S. government debt due in 10 years or more has returned 14 percent this year, the biggest year-to-date gain in almost two decades, index data compiled by Bank of America Corp. show. Yields on the 30-year (USGG30YR) bond, the longest-maturity security, have fallen faster this year than at any time since 2000.
America’s growth prospects mean yields on U.S. government debt are now too low to compensate for the risk, according to Erik Weisman, a money manager at Boston-based MFS Investment Management, which oversees $430 billion.
While the economy stumbled in the first quarter, employers have still added more than 200,000 jobs for six straight months.
Economists surveyed by Bloomberg say gross domestic product will increase 3 percent next year in the fastest expansion in a decade, after rising 1.7 percent this year.
“This is a reason to think of lightening up” on Treasuries, Weisman said in an Aug. 5 telephone interview.
Forecasters also predict bond yields will rise through year-end. They estimate yields on 10-year notes will climb more than a half-percentage point to 3 percent, based on the median projection in a Bloomberg survey.
Jack McIntyre, a Philadelphia-based money manager at Brandywine Global Investment Management LLC, which oversees $45 billion, says even as the U.S. economy gains momentum, inflation will remain subdued because businesses now have much more leverage than workers when it comes to pay.
Unlike in the 1970s, when wages climbed an average 7 percent annually, cheaper overseas labor, technological gains and the decline of labor-union influence all mean companies can squeeze more out of employees for every dollar paid, he said.
Last quarter, a measure of U.S. productivity climbed more than economists anticipated, helping to restrain labor costs to an increase of just 0.6 percent per worker.
It’s a “key part of our thesis” for owning longer-term Treasuries, McIntyre said in an Aug. 5 telephone interview.
The proliferation of low-paying jobs during this expansion is also a signal to NineAlpha’s Evans that the Fed can keep borrowing costs low without worrying about inflation.
The joblessness for food preparation and serving-related workers has fallen about twice as much as the unemployment rate in the past year. The hiring gains include jobs being added at fast-food chains such as McDonald’s Corp. and Wendy’s Co., which pay less than $10 an hour on average.
“My concern is that a lot of jobs being created are either part time or at the lower end of the food chain,” Evans said. “If that’s the real nature of the jobs being created, then the Fed can afford to be patient.”
To contact the reporter on this story: Daniel Kruger in New York at firstname.lastname@example.org