Federal income and employment taxes are surging, and that may mean financial markets are underestimating the pace of Federal Reserve monetary tightening this year.
There's virtually no chance of a rate hike when Fed policymakers finish their latest meeting Wednesday, and markets already expect a hike in June. But if wage gains have shifted into higher gear, as the daily data on taxes withheld from worker paychecks seem to indicate, then markets may have a surprise in store as soon as September.
Over the past 10 weeks through April 26, withheld taxes have surged 7.9% from a year ago, according to an IBD analysis of Treasury data that's adjusted for calendar effects.
Although it's a bit too early to definitively say that wage growth has accelerated in a big way, the tax data, along with Friday's Employment Cost Index report from the Labor Department and anecdotal company reports, suggest that investors should brace themselves for upside surprises in wage growth.
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JPMorgan Chase (JPM) CEO Jamie Diamond wrote last week that the company gave 18,000 tellers and customer-service reps a wage hike in February. Over three years, their minimum wage will rise from $10.15 an hour to a range of $12 to $16.50.
Shares of American Airlines (AAL) were pummeled last week after the company announced pay hikes of 8% for pilots and 5% for flight attendants. Morgan Stanley downgraded the airline to "neutral," calling the move "a worrying precedent, in our view, both for American and the industry."
Dave & Buster's Entertainment (PLAY) CFO Brian Jenkins told analysts on a March 28 earnings call that the restaurant chain's wage increases are hovering around 5%. "We still think it's going to be a pressure point above what we've seen in the history of this company," Jenkins said, according to a Seeking Alpha transcript.
Railroad operator Union Pacific (UNP) said on an April 27 call that it's seeing wage inflation of 5%, up from 2.5% in the fourth quarter and 2% for all of 2016.
IBD'S TAKE: Markets may no longer be banking on President Trump's trillion-dollar national building program, at least in the near term, but infrastructure investors are excited about big state spending plans. Martin Marietta Materials, the No. 1 ranked stock in IBD's Building-Cement/Concrete/Aggregates industry group, reports earnings on Tuesday.
On Friday, the Labor Department reported that private industry wages and salaries grew 0.9% in the first quarter vs. the prior three months, the biggest increase in 10 years. The 12-month increase of 2.6% only matched the post-recession high seen in the second quarter of 2016, though, so the data didn't mark a clear wage acceleration.
On a year-over-year basis, the Treasury data on withheld taxes appear to be growing faster than at any time since the recession. (Here's a long-term look, adjusted for tax hikes under President Obama, from Matt Trivisonno at DailyJobsUpdate.com.) Considering that the ranks of the employed are growing by less than 2% per year, a 7.9% rise in withheld taxes is consistent with something close to a 6% rise in wages, salaries, bonuses and other incentive pay.
Still, that likely overstates labor market strength to a significant degree, because this year's strength partly reflects weakness seen in the first quarter of 2016, when the economy was buffeted by global financial market turmoil. Because the bonus season lasts until March 31, this year's rising tax revenue probably reflects bigger bonuses, at least in part. Yet, the data from April, after this year's bonus season, still show tax revenue running strongly ahead of last year's pace, so there's some reason to think that an upturn in wage growth may finally be at hand.
The Fed's belief is that the U.S. is already close to full employment and that higher wage growth, when it comes, is likely to flow through to higher inflation. The minutes of the Fed's March meeting, which were released on April 5, indicated that policymakers believed the time had come to begin shrinking the central bank's bloated balance sheet, which would act a monetary tightening.
When the government bonds and mortgage securities held by the central bank mature, the Fed now reinvests all proceeds, meaning no change to the size of its balance sheet. If the Fed stops investing every dollar of its returned principal, the balance sheet will shrink, an effective tightening of policy.
As of now, the Fed's preferred timetable includes "rate hikes in June and September, and the first step in the (Fed's) balance sheet normalization process in December," wrote Ward McCarthy, Jefferies chief financial economist.
Right now, markets aren't buying the Fed's base case. One reason is that investors no longer think the economy will get a big dose of President Trump's fiscal fuel this year via tax cuts and infrastructure spending. Yet clearer evidence of stronger wage growth, which could come as soon as Friday's jobs report, may quickly shift the market's thinking, leading to higher Treasury yields.
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