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30° Of Separation And Cheshire Cat’s Revenge

"We're all mad here".

On Tuesday, at a speech in Boston, Jerome Powell said this about the Phillips curve:

I do not see it as likely that the Phillips curve is dead, or that it will soon exact revenge.

The debate about when and if, the Phillips curve will finally reassert itself with a vengeance is becoming increasingly urgent with each passing jobs report. On Friday, for instance, the September report showed the unemployment rate fell to a 48-year low at 3.7% (green annotation in the following chart just notes the sharp upward revision to the August headline which helped offset the poor optics around the disappointment on the headline print for September, denoted by the red annotation):

Payrolls

(Bloomberg)

Meanwhile, annual wage growth printed 2.8%, inline with estimates but hardly the scorching hot number that some feared in light of the ongoing bond rout.

On Wednesday, following Powell’s remarks in Boston, we rekindled the “Cheshire cat’s smile” characterization of the Phillips curve. “In each cycle, it falls apart, but after every annihilation, it re-composes itself and continues to play an important role”, Deutsche Bank’s Aleksandar Kocic wrote back in June, in a characteristically brilliant note.

He continued, adding that the Phillips curve “appears ‘indestructible’, but not in a conventional way, more like a survivor of one’s own death [and] functions like an organ without a body, an equivalent of Cheshire cat’s smile (in Alice in Wonderland) that persists alone, even when the cat’s body is no longer present.”

In that June note, Kocic employed a visual history of the Phillips curve that documents the “annihilation” and subsequent “re-composition” throughout history. In that visual, he demonstrated that in late-stage expansions there always comes a point when the market witnesses a virtually straight-line rise in wage growth in response to even small improvements in the economy.

On Friday, Kocic updated that visual to show that when it comes to the straight-line rise in wages (represented on the chart as a 90° angle) that typically accompanies incrementally good news on the economy when the recovery is long in the tooth, we’re not quite there.

“Phillips curve, although steeper than it was for many years, is still not in the area suggestive of overheating”, Kocic writes, before reiterating that “in previous cycles, when unemployment rate was below NAIRU, during the last leg of the recovery wages had shown a steep rise, sloped at 90°.” Here is his updated visual which shows the current slope holding steady at 60° which Kocic says “indicates that transmission from labor market to wages is now different than before.”

AK

(Deutsche Bank)

Kocic ties this in with the discussion about the “red zone” as documented here earlier this week. On Thursday, Kocic weighed in on the “When will equities buckle under the weight of rising bond yields?” question that’s on the tip of everyone’s tongue now that 10Y yields are sitting at their highest levels since 2011.

Kocic looks at the equity-rates correlation as a function of the terminal level of the bond risk premium, observing that “between approximately 250 bp and 300 bp over r*, these correlations change sign such that a higher BRP accompanies lower equities.”

Corr

(Deutsche Bank)

The “red zone” for the correlation to change signs appears to be between 3.20% and 3.70% on 10Y yields.

Kocic argues on Friday that what’s keeping us from landing squarely in the “red zone” is the difference between the 60° slope of the Phillips curve and the typical ~90° slope that plays out in late-stage expansions when the curve finally “exacts revenge”, as Jerome Powell puts it. “This is the 30° cushion that separates us from the ‘red zone'”, Kocic says.

He also notes that reals have led the selloff this year. This week, 10Y real yields topped 1%, which appeared to be what weighed on equities Thursday and Friday.

Reals

(Bloomberg)

“Depending on how rates rise beyond these levels, we could have two different paths”, Kocic goes on to say, before reminding you that “higher rates through wider breakevens are generally supportive for stocks and erosive for bonds, while higher real rates have the opposite effect across the two markets.”

Finally, it’s worth noting that if/when the stock-bond return correlation does flip sustainably positive (equity-rates correlation flip negative), it creates a potentially self-feeding loop for pension flows. “A change in sign in equity/bond correlations could potentially become circular”, Kocic’s colleague Stuart Sparks warns. After all, if you rebalance into fixed income after a period of equity outperformance, and you rebalance into equities after periods of fixed income outperformance, what do you do when both are selling off?

Fortunately, there’s still “30 degrees of separation” (to quote Kocic) between now and when the sign on the correlation flips. Or so one hopes.


 

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2 comments on “30° Of Separation And Cheshire Cat’s Revenge

  1. Have read about the Phillips curve now often enough that it is almost starting to make sense… so do I sell everything and hold cash and wait for the inevitable? Is it already too late? There doesn’t seem to be any point in tempting fate anymore.

  2. Pingback: ‘Fatal Attractions’ And Speed Limits – PortfolioThought

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