Tick Tock Where Does the 2-Year Stop?

It’s been an interesting two weeks of macro inflation headlines. On September 7, the Bureau of Labor Statistics (BLS) reported average hourly earnings increased 2.9%, or the largest year over year increase since 2009. Meanwhile, the Fed’s Beige Book was released last week, highlighting the difficulty companies are having finding sufficient labor. The report stated, “Labor markets continued to be characterized as tight throughout the country, with most Districts reporting widespread shortages.”

The picture below (provided by a reader) is one of the many help wanted signs sprouting up across the country. Based on company reports and commentaries, entry level positions continue to be difficult to fill and are often paying well above minimum wage. These are similar to the wages Jesse Felder and I discussed in his podcast on inflation. In effect, we weren’t crazy after all — $12 to $15 an hour appears to be the new minimum wage in many regions.   

With the latest reports on labor confirming wages are indeed rising, I was beginning to believe the market’s “Inflation Recognition Moment” was finally approaching. However, just as I was getting my hopes up, last week’s PPI and CPI reports came in below expectations (PPI -0.1% and CPI +0.2%).

Shortly after the PPI was released, a reader asked, “Shouldn’t the inflation you’ve been writing about show up in the PPI?” I responded, “After I saw the PPI declined -0.1% I emailed my former analyst and asked him to name one producer experiencing lower costs. He couldn’t think of one. And I couldn’t either!”

In effect, the corporate cost trends I’ve been documenting over the past year do not appear to be reversing. That said, I remain open-minded to changes in inflationary trends, especially if the dollar rises sharply (similar to 2014) or asset prices collapse. However, based on my bottom-up analysis, real world inflation in wages and operating expenses continues to be a common theme for many businesses.

Since I began noticing rising corporate costs in 2017, the 2-year Treasury yield has increased considerably. I continue to be amazed by the 2-year’s determination to march higher, not to mention its steep slope. It’s one of the most exciting, underreported, and important trends in the financial markets, in my opinion. Trading near 0.50% only two years ago, the yield on the 2-year hit 2.79% today! As someone patiently waiting for the current market cycle to end, I’d like to know the rate the 2-year needs to reach before something in the financial system cracks.

During the past two market cycles, the 2-year Treasury yield topped near 5-6%. Can short-term rates reach similar levels this cycle? While I believe current trends in the labor market and inflation support mid-single digit interest rates, the U.S. government’s fiscal position is much weaker this cycle. In 1999, the United States was generating a fiscal surplus vs. a deficit of $895 billion during the first 11 months of fiscal 2018. And in 2007, federal debt was significantly lower ($9 trillion vs. $21 trillion today or 62% vs. 107% debt to GDP). Based on current debt levels and fiscal deficits, can the U.S. afford a doubling of its interest expense?

And what about asset valuations? It will be very difficult to justify 3% normalized earnings yields on equities assuming 2-year Treasuries are providing 5-6% yields – not to mention the trillions of dollars of other investment decisions made while interest rates were pegged near 0%.

Of course, many investors believe the 2-year Treasury will never reach previous cycle yields of 5-6%. In addition to there being too much debt, the Federal Reserve has become increasingly sensitive to financial instability and the consequences of deflating asset bubbles. Maybe so, but someone needs to tell the 2-year and rising inflationary trends – they don’t appear to be listening.

In my opinion, the maximum 2-year interest rate the market can withstand will ultimately determine when the current cycle ends. If asset prices can hold together until 5-6% yields are reached, the cycle could last another two or three years (assuming the continuation of gradual rate increases). Or maybe the peak 2-year rate this cycle is near current levels. I really don’t know, but I continue to watch the 2-year closely as it marches higher without interruption or concern. In essence, I view the 2-year yield chart as my market cycle countdown clock. After being stuck for so many years (2009-2016), it’s nice to see the clock is ticking again!


To summarize and highlight many of the inflationary pressures the companies in corporate America are experiencing, we recently released a new report on The Bottom-Up Economist. For those who haven’t subscribed, you can find the report on the following link (BUE September Report).

Thanks for checking out our new website and all of the feedback – it’s been very helpful. If you have any questions or would like to submit a request for future reports, please contact us at BUE@thebottomupeconomist.com.