Please fasten your seat belt, we're beginning our labour market descents

Central banks across the major developed economies are likely finished raising interest rates in this current monetary policy cycle. After seeing policy rates move from record lows to post-GFC highs, the focus is shifting to when, and how aggressively, rates are lowered. Currently the market is pricing anywhere from two rate cuts (Australia) to six rate cuts (United States, Eurozone), and the differences reflect both the starting point and the scale of the economic headwinds emerging.

The narrative around interest rates tends to have a heavy focus on wages. The rationale (laid out by central banks over the past several years) is that wage dynamics explain much of the movement in services and core goods prices, and these are the parts of the consumer price index that central banks target. This is the case in Australia, the United States and almost all developed economies. Across emerging economies wage dynamics are less important because labour is in relatively better supply and it is shortages of capital (equipment, raw materials, intellectual property, etc.) that typically trigger bouts of inflation and vice versa.

Having strengthened to varying degrees over the past few years, the outlook for labour markets and wages ranges from no landing, to soft landing, or hard landing. Official unemployment rates are beginning to move higher across most economies – United States (+0.3%), Canada (+0.9%), Eurozone (unchanged), United Kingdom (+0.7%), Australia (+0.5%), and New Zealand (+0.7%). Meanwhile, wages growth remains elevated and is only showing tentative signs of slowing in some economies.

But the important point to note is that the unemployment rate leads wages. This relationship holds across time and across economies. This is why we see the ‘no landing’ scenario as very unlikely to eventuate. Descent is underway and it now becomes a question of whether we achieve the ‘soft’ landing central banks are currently forecasting, or the ‘hard’ landing which sees unemployment rise considerably and all but guarantees a recession.

We monitor many economic indicators which have good track records in predicting movements in unemployment rates, and currently they’re sending quite worrying signals.

In Australia and New Zealand, data on job advertisements implies a further rise in the unemployment rate. We should expect to see rises towards levels observed in 2018-2019 which triggered rate cuts (from much lower starting points) from the RBA and RBNZ.

In the United States and Canada, leading indicators imply similarly large moves in unemployment rates. These would also see unemployment rates at levels which triggered rate cuts in 2019.

The United Kingdom is also likely to see its unemployment rate rise, but perhaps less so compared to other economies in our coverage. At least some of the difference is explained by the lack of inward migration compared with Australia, New Zealand, and Canada. And finally, Japan is the only economy where the unemployment rate is likely to move sideways. This goes a long way to explaining why the market is pricing rate hikes in Japan and strong wage outcomes for the all-important March-April 2024 reporting season. Of course, the low starting point of interest rates in Japan is also a major factor.

Why the intense, bordering on obsessive, focus on unemployment rates and leading indicators? Because one of the most accurate real-time indicators of United States recessions relates to the unemployment rate. The Sahm Recession Indicator states the beginning of a recession in the United States is when the unemployment rate (3-month moving average) rises 0.5 percentage points relative to the 12-month low. This is a threshold the official unemployment rate hasn’t yet crossed, but one the leading indicators suggest we will cross at some stage in the next 6 months or so. And not just in the United States, but in several other economies too. While the Sahm Recession Indicator specifically relates to the United States, a strong case could be made in respect of its applicability to the other economies we discuss. Perhaps the threshold is slightly different in Canada where the unemployment rate sits structurally higher, but the general principle very much applies.

As is always the case, the labour market is the core but far from the only factor driving economic growth (or a lack thereof). The trajectory of fiscal spending and the level of accumulated savings (largely driven by past fiscal largesse) are important factors too. We could comment at length on each, but to avoid a War and Peace length note, we can just say they’re both important in determining the timing and depth of rate cutting cycles, and the shape of interest rate curves. A timely example is in New Zealand, where the government recently revised its borrowing (government bond issuance) higher and is planning for much of the issuance to be in the form of longer-dated securities. This puts upward pressure on longer-dated yields and is one of the reasons we expect the yield curve to continue steepening in New Zealand. And, sadly, New Zealand isn’t the exception but rather the rule when it comes to fiscal policy and long-dated government bond issuance. The perils of United States government finances are well known, the European Union is debating relaxing government debt rules, and the United Kingdom seems to always be looking for ways to increase government spending.

There are two particularly important dynamics we’re tracking as it concerns fixed income portfolio management in the early months of 2024. The first is keeping close track of market implied rate cuts as participants wax and wane over central bank decisions. Currently some markets are pricing less easing and screen as attractive relative to others pricing several rate cuts. And the second is utilising yield curve strategies to navigate an environment where shorter-dated yields likely continue to fall but longer-dated yields (and the benchmarks they dominate) struggle to keep pace in the face of fiscal policy headwinds.

It’s likely to be a bumpy landing!

Joshua Rout is a Research Analyst within the Franklin Templeton Fixed Income team in Melbourne, Australia which manages the Franklin Templeton Australian Absolute Return Bond Fund (ASRN 601 662 631).