Powell Pumps as Wages Get Revised Up...
Financial conditions continue to ease, wage inflation continues to confound, and the future of Market Making...
Welcome back to Market Making, your weekly dose of sell-side research and insight.
⏱️ Estimated Read Time: ~23min
✍️ Word Count: ~4,795
📚 This week’s Reading List has been updated
Part 1: The Future of Market Making
While I figured that folks would enjoy reading a newsletter like this, I’ve been blown away by the response: every few days I get e-mails from people saying how much they’ve enjoyed reading the newsletter and thanking me for putting it together.
And to say that getting e-mails like these has been deeply rewarding would be a rather large understatement — indeed, some e-mails have been so filled with kind words that they’ve truly made my day.
When I decided to begin writing Market Making I had two overarching goals: to write something every week that would give folks a peak behind the curtain at how those in the world of institutional sales and trading are thinking about markets, and to write something every week that would be deeply enjoyable to read.
But I’ve come to realize that there’s a reason why others in the industry don’t write 5,000+ words every weekend on markets for a general audience: it takes a lot of time!
Indeed, some of the newsletters I’ve written in recent weeks have been 10% the length of an average novel. While I’m a pretty quick writer, that’s a lot of content to pump out in just a few days, no matter how quickly my fingers traverse the keyboard.
Of course, I knew writing this kind of newsletter would be a time commitment. But I also knew that folks would enjoy reading it and, just as importantly, that I’d enjoy writing it.
But in the past few weeks - as my real work schedule has heated up - I’ve found it harder to enjoy the process of writing the newsletter; mostly because I haven’t been able to write as well (from a stylistic perspective) as I would like.
So I’ve decided there needs to be a change in the structure of the newsletter, the only question is what that change should be…
Stopping or Slowing…
Over the past few weeks I’ve been mulling over a few different directions I could take the newsletter.
The first, and most obvious, involves just stopping it. In almost every conceivable way, this would be the more rational choice as writing the newsletter does take a bit of time away from my real work which is (obviously!) much more important.
However, it has been deeply heartening to get so many kind e-mails about the newsletter and I love breaking down market dynamics, discussing theories behind what’s impacting markets, and writing it all in a way that’s (hopefully!) a pleasure to read.
So, I think what makes the most sense is not stopping the newsletter, but rather slowing it down (perhaps I’m just subconsciously acting in solidarity with Chair Powell by slowing the pace of publishing, just as he’s slowing the pace of rate hikes!).
After a great deal of thought, here’s how I’m envisioning the newsletter moving forward…
Instead of publishing a newsletter every Sunday evening - that’ll often take 25-35 minutes to read - I’ll publish one every month that’ll take 35-65 minutes to read (or more!). What this change will allow me to do is really take a step back, focus on the most important market themes, and try to creatively explain concepts.
Most importantly, from my vantage point, it’ll allow me to enjoy the writing process much more — which is a large reason why I started the newsletter to begin with!
Structurally, the newsletter will be similar to how it is now: free members will always be able to read the entire first part of the newsletter, and premium members will get to read everything else.
Further, premium members will get access (just as they do today) to my reading list, which will still be updated every week with my favorite sell-side research and everything else I’ve been enjoying reading over the past week.
However, since the newsletter will be published once a month, not every week, the price of the premium tier will be slashed to just $10 a month — that way it’s even more affordable to everyone. And, of course, there’s no obligation to stay subscribed for more than a month if you don’t want to.
So, in summary, there will now just be one newsletter a month — but it’ll be even longer than the prior iterations. Free members will still be able to read the first part entirely for free, and premium members will be able to read the whole thing along with gaining access to everything in my reading list (which will still be updated weekly). But, for premium members, the price will now be much lower than it was before.
In the end, this strikes me as being a much better balance. I know many have grown to really look forward to reading the newsletter every Sunday, so hopefully you aren’t too disappointed in the slower pace. Moving forward, I think this will allow for a much better balance given how relatively little free time I have.
Note: If there’s ever any major story or development, I’ll probably end up sending a shorter newsletter at the time to discuss it and then do a deeper dive on the subject during the primary monthly newsletter. So, there will be at least one deep dive newsletter a month, but maybe one or two more small ones if I have the time.
In the end, this newsletter has always been a hobby for me — something that can help others and gives me an excuse to write, which is something I love doing.
This is also why I’ve always tried to price the premium version as low as possible: enough to not make this an insane misuse of my time, but also low enough so that anyone who’s interested can easily afford it. As you can imagine, relative to my real job, this newsletter doesn’t exactly make me much of anything — but that’s not the point of it, so that’s perfectly fine with me.
Note: For current premium members, in the last section of this newsletter I’ll discuss the logistics of moving to this new monthly model. As I mentioned last week, I paused your subscription weeks ago so that you wouldn’t be billed at all moving forward, but you still have full premium access. As always, you can e-mail me with any questions. :-)
The Re-Opening of Market Making…
Several weeks ago I “paused” the ability of people to sign-up for the premium version of Market Making as I decided whether to continue writing or not (since I didn’t want anyone to sign-up just a week or two before I stopped writing).
Right now, subscriptions are still paused, so you still can’t sign up for the premium version. However, in the coming weeks I’ll send out an e-mail when I’ve “unpaused” subscriptions and you’ll then be able to sign up at the new monthly rate of just $10.
When you sign up for the new rate, you’ll also get immediate access to my reading list - which I’ll still be updating every week - along with all the past archives of Market Making. So, I think it’s a pretty good deal and (hopefully) something you’ll enjoy!
Part 2: Financial Conditions Ease, Wage Growth Squeezes
As I mentioned in last week’s newsletter, I was in the London office for most of this week and just got back yesterday. So there won’t be quite as long of a newsletter as normal.
Instead, the first new “monthly” edition of Market Making (a.k.a. the one that will take an ungodly amount of time to read!) will arrive sometime between Christmas and New Year’s Eve. I’ll make it really special and I’m looking forward to putting it together — it’ll likely cover the December FOMC meeting, my thoughts on rates moving forward, whether we’re primed for an earnings recession, the major themes for January, and much more.
But let’s quickly cover some of what happened this week, as it was pretty eventful…
In past weeks we’ve talked extensively about how the dominate theme of next year will surround rates divergence. However, maybe the dominate theme will actually be meta-divergence — or, in other words, the divergence of everyone’s views on everything.
Because there has seldom been a time in which the views of investment banks have been more divergent over the path of everything moving forward (i.e., BofA and GS having wildly different recession outlooks).
This week started with a kind of murmur with low liquidity pervading almost all asset classes. The two major events everyone was gearing up for were Chair Powell speaking on Wednesday at Brookings and then non-farm payrolls on Friday.
Note: There were other pieces of data released this week (i.e., JOLTS on Wednesday, which surprised to the upside again!). But these pieces of data were small potatoes relative to Powell and payrolls.
We talked about the uncertainty of what exactly Powell would say last week. In the face of loosening financial conditions prior to Jackson Hole and his last FOMC press conference, he used hawkish rhetoric to try to beat down risk-assets and tighten financial conditions.
But the question was whether or not the softer-than-expected inflation print we got last month would change his calculus: would he possibly be a bit more sanguine about financial conditions having eased given that inflationary pressures appear (at least based on a handful of data points) to be on a downwards trajectory (especially since we’re still a long way from being near target).
Like many market participants, my reaction function was predicated on just how much Powell would push back on financial conditions having eased. In other words, it wasn’t a matter of if he would — it would just be the degree of hawkishness we’d see.
But instead he largely side-stepped any discussion of financial conditions, opting to rehash some tried-and-true lines about keeping rates higher for longer while more-or-less endorsing a 50bps hike for the next meeting (to no one’s surprise).
Here’s a nice summary of Powell’s remarks, courtesy of JPM…
While there are a few more Fed speakers between now and the blackout period, today Chair Powell effectively got the last word in before the December FOMC meeting, which is two weeks from now. He used the opportunity to cement in place expectations for a downshift to a 50bp hike at the meeting, while also reiterating that “restoring price stability will require holding policy at a restrictive level for some time.” The market took Powell’s remarks as dovish, or at least less hawkish than expected; we generally agree. Insofar as he repeated many of the themes from the November FOMC press conference and minutes, it doesn’t seem as though he were pushing back against the easing in financial conditions that has occurred since that meeting. Of course, it’s difficult to micro manage market expectations, and in the bigger picture the Fed leadership is continuing to vow to“stay the course until the job is done.” However, there is little sense that their level of alarm at the inflation situation is rising.
The fact that there was no pushback at all against financial conditions having eased had the predictable effect of, well, easing financial conditions further by causing a massive risk-on rally…
After the last CPI-print, we talked about how the non-profitable tech basket had it’s largest single day move ever, a sign of how the market was reacting in a fully risk-on manner.
Powell’s speech, whether he intended to or not, had a similar risk-on impact as it unleashed a more modest (but still substantial) move north of 7% in this basket…
To give a sense of just how much the market was waiting on Powell’s remarks, here’s a few great stats from Goldman…
*VOLUMES–15.26B shares across all exchanges...was-25% vs. 20dma heading into the JPow meeting...finished +46%...This was in partly related to the massive close...Understatement that everyone was waiting for Jerome...
And here’s a nice (sober) summation of Powell’s remarks that was published by a GS trading desk shortly after the speech concluded — noting that while easing financial conditions wasn’t explicitly brought up by Powell, it also wasn’t asked about, so be careful how much you read into its omission…
Powell didn't have any direct push-back on FCI easing in text and the topic somewhat surprisingly was not brought up in Q&A (Brookings and Fed likely coordinate to some extent ahead of the event, so this could have been a deliberate choice, but hard to know for sure.) Closing 2sentences read as more hawkish than dovish to some on the desk, but the market clearly wasn't fazed: "...It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done."
It’s difficult to say how much Powell anticipated the level of easing he ended up unleashing. While he made a deliberate decision not to talk down the markets the way he did (with no ambiguity) in Jackson Hole or after the last FOMC meeting, he likely didn’t anticipate such a sharp risk-on market reaction.
To my mind, the market reaction (especially since it didn’t continue into Thursday and Friday) was less interesting than the speech itself…
Because when you dig beyond the surface level of Powell’s speech (i.e., the fact that he didn’t use explicitly hawkish language) what you find is actually relatively keen insight into his own reaction function — a reaction function that became all the more important after some surprising (to some, shocking) data we got on Friday.
Once again, JPM summarized the core of Powell’s speech well…
More specifically, and turning to the body of the speech, Powell broke core inflation into three pieces: core goods, housing, and core services ex-housing. In two of those — core goods and housing — he saw reasons for optimism. The outlook for core services ex-housing is more uncertain and is the segment he saw as most linked to wage inflation. On wage inflation, he saw “only tentative signs of returning to balance,” though it remains above what is consistent with 2% inflation. In Q&A he said wage inflation around 3.5% would be consistent with more favorable inflation outcomes; most measures are currently around 5%. Powell spent quite a bit of time on labor supply, even though he conceded the Fed doesn’t affect it. On labor demand, he also saw tentative signs of moderation, with more needed. In summary, “Despite some promising developments, we have a long way togo in restoring price stability.”
This is a fantastic mental model for thinking about our current inflation. What Powell is trying to illustrate is that for inflation to come down to target, it’s not enough to merely observe flat or modestly deflationary readings in core goods and housing.
While it’s great that those are trending in the right direction, core services ex-housing needs to moderate substantially (even if it remains above target) to be consistent with returning to the overall target rate.
However, the rub is that core services ex-housing is most closely linked with wage inflation, and the level we’re observing in wage inflation (something I’ve been talking about constantly!) is well above levels that are consistent with returning to target.
Interestingly, even though Powell is often remiss to ever explicitly mention specific levels that he has in mind for informing a return to target inflation, he does throw out there that wage inflation of 3.5% would likely be consistent with returning to target inflation.
The reality is that measuring wage inflation is a messy enterprise — with many measures that are all pointing to levels above 3.5%, but with a reasonable spread between them (i.e., we’ve talked before about the Atlanta Fed’s wage tracker ticking up last month to 6.4% after falling from 6.7% in September to 6.3% in October).
On Friday, the release of payrolls (that beat expectations, yet again, despite how tight the labor market already is) came attached with average hourly earnings — a measure of wage inflation I’m not a huge fan of, given that it needs to be considered in light of the number of housing worked - but that is nevertheless a widely discussed wage inflation measure.
To put into context just how unideal this data was, here’s a tweet from Jason Furman, who’s now at Harvard and someone I frequently cite in my weekly reading list as someone you should read.
Note: When Jason says “jobs report” he’s not referring to the higher-than-expected payrolls numbers, but rather the average hourly earnings numbers that are part of the jobs report (as we’ll get into below).
And here’s Paul Krugman, who was previously (as in, just a few days ago) chiding the Fed for over-tightening because inflation was on the march downwards…
Here’s the cause for concern: average hourly earnings were trending (modestly) down in prior months, and approaching levels that could be consistent with a return to the Fed’s inflation target into 2023 (i.e., wage inflation getting to around 3.5%, as Powell was discussing in his speech).
However, not only did average hourly earnings double market expectations by coming in at 0.6% MoM on Friday, but the past two months (September and October) of average hourly earnings data were revised higher as well.
…When mixed with payrolls beating (263k vs. 200k expectations) this doesn’t signal that wage inflation is abating anytime soon.
Last month, before the revisions to the September and October data took place, three-month average hourly earnings grew at an annualized rate of 3.8% (getting close to the territory that Powell cited!).
However, with the revisions to September and October, along with this new data for November, the three-month average hourly earnings growth rate is now 6.0%. So we’ve gone from just north of Powell’s target range to nearly double it when accounting for these revisions.
Here’s a great chart from Jason showing where we are now, taking into account the revisions that we received on Friday…
Note: September average hourly earnings were revised from 3.8% YoY to 4.5% YoY while October was revised from 4.9% to 5.7% YoY — November’s annualized rate would be 7.8%.
While having a measure of wage inflation go up by double market expectations is never a good thing, if it were an isolated data point then one could wonder whether or not it’s more noise than signal. However, with the revisions in September and October occurring, both running at rates well above anything compatible with target, that means this is unlikely to be noise: rather, wage inflation is still running very hot.
And what this means practically is that Goldman’s job-workers gap inflation framework is looking increasingly precarious. With job openings surprising (for the second month in a row!) to the upside, and wage inflation running much hotter than anticipated, this is all reflecting a steady-state inflation rate in the 4-5% range unless meaningful labor market slack (unemployment!) is introduced soon.
Put another way, even with deflationary impulses stemming from core goods and housing (two of the three areas highlighted by Powell), with wage inflation running so far north of expectations it’s unlikely we’ll see core services ex-housing moderate enough to be consistent with the Fed’s inflation target over the near-term.
This is especially true given that the personal savings rate we got this month shows the second lowest level since 1959. Meaning that the wage gains that consumers are getting are being spent in the economy immediately — not being socked away in a drawer and thereby not contributing to further inflationary pressure.
As BofA puts it…
The strong October spending data pushed the saving rate lower to 2.3%, the second lowest reading in the history of the series dating to 1959. The saving rate could even turn negative if excess saving is drawn down rapidly. The downward revisions to household saving mean that excess savings in the economy are smaller than we previously estimated. In the past we have calculated excess savings by using the Feb 2020 saving rate to calculate trend savings. This approach suggests excess savings of around $930bn, which should last about another eight months based on recent trends.
And here’s a great chart, also from BofA…
As personal savings decline and households feel the pinch, in a tight labor market this logically results in more wage bargaining occurring (i.e., people demanding raises both because they feel they can get them, since labor markets are so tight, and because they feel they’re falling behind financially).
In the UK - where inflation is running hotter, real incomes are lower, and a recession is already underway - there has been a steep rise in strikes occurring as folks, rationally, demand higher wages to try to keep up their standard of living. Needless to say, this may be rationale for any one individual to do, but it’ll spur yet higher levels of inflationary pressure that will be felt by everyone moving forward.
In the end, a return to the Fed’s target, and to overall price stability, requires wage inflation to moderate and, since it’s not rationale for any one individual not to demand a raise if they have bargaining power, the way you achieve the necessary aim of bringing down wage inflation is through increasing unemployment.
The key question will be: how much unemployment is necessary to bring down wage inflation (since many industries appear to have structural labor market shortages due to the amount of retirements that occurred during the pandemic) and how far will the Fed need to raise rates to induce more unemployment (as that’s the only tool in the toolbox they have for doing so).
Here’s a snapshot showing average annual earnings and what various MoM prints will do over time — note that the 0.6% MoM print we got on Friday sends us in the wrong direction here from already elevated levels…
Against this wage inflation backdrop, forward-looking data appears to be aligning with a recession occurring next year (something BofA has been calling for with increasing levels of conviction, but that others, like GS, have been unswayed by thus far).
As I mentioned at the outset of this newsletter, there’s an increasing level of divergence among banks on whether we’ll have a recession, the severity of any recession if it is to eventuate, and just how much of a recession would be needed to get unemployment up to levels that would be consistent with wage inflation returning to normalized levels.
Because here’s something to keep in the back of your mind, and that may become more of a talking point moving forward depending on what occurs over the next year: if we have wage inflation running well above 3.5%, but a shallow recession, that could lead to inflation appearing to have been tamed due to the deflationary impulses from core goods and housing even though core services ex-housing may still be running well above 2%.
But then, as we come out of the recession, we’d expect inflationary impulses from core goods and housing which, if mixed with still strong wage inflation and core services ex-housing, could get us right back up to the 3-5% inflation range.
Keep in mind that the inflationary dynamic pre-pandemic was that most everything was running slightly above or slightly below target — having a scenario in which some things are running well below target, and some things well above, is not an ideal mix.
After all, what the Fed wants to return to is not just their inflation target, but to a world of price stability. But it may be easier to achieve the former than the later.