Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
We’ve yet to get the official report on real GDP for the final quarter of 2017, but we’re expecting the Bureau of Economic Analysis to report the economy expanded by 2.5 percent. The economy is near full employment with the official unemployment rate at 4.1 percent, while non-farm payrolls expanded at an average of about 175,000 a month. Economic and financial themes for 2018 will likely include continued synchronized global growth, albeit at a somewhat slower pace, modest inflation, a gradual withdrawal of monetary stimulus and elevated geopolitical concerns.
On a year-over-year basis, headline inflation, expressed as the consumer price index (CPI), likely increased at a rate of just over 2 percent in 2017. At the same time, the Federal Reserve’s preferred measure of inflation, core personal consumption expenditures (PCE), which exclude food and energy prices, expanded by 1.5 percent.
A less accommodating Fed, excessive debt loads and aging demographics were headwinds for the economy in 2017. Tailwinds included increased use of robotics and automation while the economy benefited from relatively low interest rates and oil prices, decent consumer confidence and spending, and the expectation of regulatory relief and lower taxes. The outlook calls for more of the same in 2018, but some of the tailwinds are expected to subside.
Look for gradual increases in interest rates as U.S. GDP expands by 2.25 to 2.75 percent. Aggregate demand is expected to fuel continued growth while a weaker dollar aides U.S. competitiveness in foreign markets. However, a weaker dollar may push inflation higher as core PCE inflation is expected to approach the Fed’s 2 percent target. Rising costs for services (i.e., housing and medical) and energy are expected to exert upward pressure on prices.
Moderate growth and rising inflation is expected to provide the Federal Reserve the justification needed to continue raising short-term rates. The Fed has made it clear that it plans to continue removing monetary stimulus as it works to “normalize” monetary policy rates, which implies an eventual federal funds rate of 2.75 percent. The funds rate is currently at 1.5 percent, which is referred to by the Fed as the target range of 1.25 to 1.50 percent. This likely translates into five more rate hikes over the next couple years – three rate hikes this year and two in 2019. Some forecasters see the possibility of four rate hikes this year. The next rate hike is expected following the March 20-21 Federal Open Market Committee meeting.
Rate hikes by the Fed will cause the Treasury yield curve to flatten, or potentially invert. In the past, Treasury curve inversions have preceded recession; in the post WWII era, every time the curve has inverted a recession has followed. An inversion occurs when shorter-term Treasury yields, which are controlled by the Federal Reserve through monetary policy, are higher than long-term yields. The Fed is hoping wage growth will accelerate as consumer and business spending spurs economic growth and pushes longer-term rates higher.
Other activities at the Fed include welcoming a new chairman and continued reductions to its investment holdings, which expanded greatly from numerous rounds of quantitative easing (QE) from November 2008 to October 2014. During this time the Fed’s balance sheet expanded from $0.9 trillion to $4.5 trillion. Since it ended QE in October 2014, it maintained the size of its balance sheet by reinvesting maturing principal.
In October 2017, the Fed said it would begin shrinking its balance sheet by not reinvesting all of its maturing Treasury and Agency mortgage-backed securities. The rate of decrease has been gradual, but will reach $50 billion per month by the end of this year. By the end of 2018, the balance sheet will have decreased by $450 billion, or 10 percent. The process of trimming its balance sheet, referred to by some as quantitative tightening, is expected to add mild upward pressure on longer-term yields.
In February, Jerome Powell will take over the leadership at the Federal Reserve. He will replace outgoing Fed Chair, Janet Yellen. Powell is currently a member of the Federal Reserve Board of Governors and has served since 2012. It’s expected he will be sworn in on Feb. 5. Unlike most Fed Chairs, Powell is not an economist by training, but is a lawyer and former partner at a large private-equity firm. Powell is expected to maintain current policy guidance and transparency. On the regulatory front, he indicated in his confirmation hearing that he is open to “tailoring” bank regulation to ease the burden on small banks.
Geopolitical worries include ongoing tensions between the U.S. and North Korea while strains between the U.S. and Russia may ease. For Europe, Brexit negotiations will likely present numerous risks while the European Central Bank is expected to talk more about tapering their QE program.
The Italian government will try to reformulate parliament in early March following national elections. Italy may face political turbulence as opinion polls currently show the anti-establishment Five Star Movement ahead of the ruling Democratic Party. For the U.S., the debt ceiling will likely move back to center stage as the Federal government is expected to run out of money by late January or early February unless Congress acts to increase the debt limit. Federal debt is currently around $20 trillion, or 105 percent of GDP.
There have been reports of escalating anti-government protests in several cities across Iran. Several people have been killed and hundreds arrested as the government has made it clear illegal gatherings of protesters will be punished. Fueling the protests is dissatisfaction with the government in Tehran and worsening economic conditions, as well as worries over rising prices for basic goods and corruption among officials.
It has been a tumultuous couple months for bitcoin as various governments intensify scrutiny of citizens with increased holdings and activity in cryptocurrencies. The market cap for the cryptocurrency market increased from about $20 billion in early 2017 to about $555 billion today. Meanwhile, in November 2017, an indicator of speculation on the New York Stock Exchange rose to its highest level since 2003. The NYSE market cap exceeds $20 trillion. These are signs that investors are adding leverage and risk to the portfolios as they try to achieve higher returns. And, while some have built a best case scenario into their outlook, it’s important to remember that market corrections are typically not gradual and the amount of speculation in the cryptocurrency market and equity markets are potential risks to the outlook for 2018.
The Risk of Recession
The current economic expansion has gone 102 months without experiencing a recession, which is the third-longest period for the past 160 years. The longest U.S. economic cycle went for a 10-year stretch that ran from March 1991 to March 2001. The second-longest expansion was 106 months during the 1960s and it’s expected the current cycle will slide into second place next summer. Depending on the impact of the tax overhaul, the recent legislation may delay the onset of a recession out to 2019.
While signs indicate continued modest growth ahead, the expansion in consumer credit, a declining trend in the savings rate, the potential weakening in consumer spending and ever-increasing burden of Federal, state and local debt remain worrisome and could alter the outlook for continued growth.
The New York Federal Reserve places the odds of a recession within the next 12 months at about 11 percent. Their forecast is based on analysis, which relies on the slope of the Treasury yield curve as a predictor of future economic activity. Some argue the ability of the curve to predict recessions has been weakened due to the large amount of monetary stimulus that was created by the major central banks over the past several years.
Others point to the correlation between oil price shocks and U.S. recessions. All but one of the 11 post-WWII era recessions were preceded by an increase in oil prices. The price increases were typically in the 30 to 60 percent range with a few episodes seeing 90 to 145 percent jumps. Key factors leading to the price instability involved strong demand occurring during periods of crisis and supply shortages. Increases in domestic production and improvements in fracking technologies may have weakened the correlation between rising prices and economic downturns. Nevertheless, keep an eye on oil prices and potential turmoil in significant oil-exporting countries.
View on Interest Rates
As markets fluctuated into year-end 2017, the two-year yield finished the year at 1.89 percent, which was near the high for the year at 1.91 percent the last week of December after dipping down to 1.14 percent in mid-February 2017. The 10-year yield ended the 2017 year at 2.41 percent, which was well inside the trading range for the year of 2.04 to 2.63 percent. The one-year low for the 10-year yield occurred in early September while the high happened in mid-March. Oil prices trended higher throughout 2017, hitting a one-year high on the last day of the year as West Texas Intermediate crude rose to $60.38 per barrel, which is up from a low of $44.01 in mid-June. For the year, WTI averaged about $52 per barrel. Worries over weaker-than-expected supply and production cuts will likely linger into 2018.
Short-term rates continue to be driven by anticipated Federal Reserve monetary policy while longer-term rates respond to inflation expectations, the economic growth outlook, equity market volatility and geopolitical events. The consensus forecast has the two-year U.S. Treasury yield finishing 2018 near 2.40 percent, as some portion of expected rate hikes by the Fed are already baked into current rates; the 10-year yield is expected to end the 2018 year near 2.75 percent.
For now, the risk of recession within the next 12 months seems modest, likely in the 10 to 15 percent range. Remain alert for potential triggers of an economic downturn, which could push longer-term rates below short-term rates, resulting in an inverted yield curve.
The above commentary is a summary of select economic conditions prepared for Northwest FCS management. It is being shared as a courtesy. As with any economic analysis, it is based upon assumptions, personal views and experiences of those who provided the source material as well as those who prepared this summary. These assumptions, conclusions and opinions may prove to be incomplete or incorrect. Economic conditions may also change at any time based on unforeseeable events. Northwest FCS assumes no liability for the accuracy or completeness of the summary or of any of the source material upon which it is based. Northwest FCS does not undertake any obligation to update or correct any statement it makes in the above summary. Any person reading this summary is responsible to do appropriate due diligence without reliance on Northwest FCS. No commitment to lend, or provide any financial service, express or implied, is made by posting this information.
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