Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
Trade was a difficult issue for 2019. However, the outlook has improved somewhat. Investors and traders are cautiously optimistic a Phase-1 trade agreement between the U.S. and China and progress by Congress on passage of the USMCA agreement between Canada, Mexico and the U.S. will ease trade policy uncertainty and bolster business confidence.
The Federal Reserve cut monetary policy rates by 75 basis points in 2019, in three 25 basis point increments, as recession risks rose on growing trade uncertainties, signs of slowing inflation and weaker global growth. For 2020, policy is expected to remain accommodative on an improved trade outlook, modest economic growth and stable inflation. The market’s view, based on federal funds futures, indicates the Fed will likely hold policy rates unchanged during 2020 with the potential for a 25-basis point rate cut later in the year. The chances of a rate hike are remote.
Unexpected extreme volatility in short-term lending markets in August and September has subsided as the Fed aggressively injected liquidity through overnight and term repurchase agreement (repo) operations. Additionally, the Fed resumed quantitative easing (QE) purchases, focusing on Treasury Bills, to further support short-term lending market liquidity. Markets have remained relatively calm the last several weeks, with no interest rate spikes like we saw in September. Traders were expecting elevated volatility going into year-end, however, continued action by the Fed provided ample liquidity and it appears their efforts were successful. Look for repo operations to taper off during the first quarter and QE purchases to wind down during the second quarter.
The U.S. economy downshifted from 2.9% growth in 2018 to a projected growth rate of 2.3% for 2019 as trade uncertainties and weaker global growth limited business confidence and spending. Rising worries over recession throughout the year pushed longer-term Treasury yields lower. A modest slowing in consumer spending on choppy gains in job growth and wages was reflected in weaker economic growth numbers. This was offset somewhat by gains in the housing sector as lower mortgage rates fueled increased activity in home sales and improved affordability. Meanwhile, the rate of inflation and inflation expectations remained relatively stable.
Many of the geopolitical issues will continue to be a concern as Brexit is expected to be set in motion by the end of January, followed by several months of painful negotiations related to new trade agreements. Foreign central banks will likely continue to expand monetary stimulus by keeping policy rates very low, or negative in several cases, with continued quantitative easing purchases. There has been no resolution to issues related to unrest in Hong Kong. Turmoil in the Middle East is expected to intensify after an American air strike in Iraq on Jan. 2 killed a senior Iranian commander who was responsible for organizing hundreds of attacks on American forces. Look for tensions in the Middle East to continue as the Iranians contemplate the timing and degree of a response. It is unknown whether allies of Iran will consider coordinating attacks on U.S. positions or allies. Oil prices moved higher on the attack. Since the U.S. is now a large producer of oil and much less reliant on imports, the longer-term impact on oil prices is expected to be muted.
Look for the U.S. economy to expand by about 2.0% in 2020 as continued low unemployment and decent wage growth maintain moderate consumer confidence and spending. Improved trade and business confidence, along with low mortgage rates, are expected to contribute to growth. Growth may be weaker during the first half of the year, followed by a stronger second half. Watch business confidence surveys, such as the monthly ISM manufacturing survey employment indicators, including the weekly report on claims for jobless benefits and consumer confidence reports. Expect an uptick in inflation metrics, but not enough to cause central bankers to tighten monetary policy rates.
Other factors to consider include:
2020 is an election year so political rhetoric will likely ramp-up as candidates for political office posture for an advantage over their opponents. Market reaction is expected to be limited until we get closer to the November elections or there is a significant unexpected development.
2019 was a good year for the equity markets. Nevertheless, it appears valuations have moved ahead of earnings projections, which is not sustainable on a long-term basis. Unless there is an improvement in the earnings outlook, we could see an equity market correction or stock prices be stagnant for some time.
The risk of a recession has subsided the past few months as the Fed eased policy rates. Current forecasts put the probability of a recession within the next 12 months, at 25%-30%. An improved trade outlook and hopes the decline in global growth will soon bottom should cause recession worries to ease further.
View on Interest Rates
U.S. Treasury yields were in transition during 2019. The 2-year yield declined from the 2.50% level to its current level of around 1.50% as recession fears and expected easings by the Fed pushed yields lower. The 10-year yield experienced a similar decline but has trended up the past several weeks as hopes of a trade deal helped propel a run-up in equity prices. Look for Treasury yields to be sensitive to future trade developments and equity market movement. Geopolitical events could add volatility to yields. Provided the U.S. economy can sustain GDP growth near 2.0% on continued low unemployment and well-behaved inflation, look for Treasury yields to trade in a 50-75 basis point trading range, centered around current levels for the next several months.
The Federal Reserve is expected to leave rates unchanged for most of the year with the potential for a 25-basis point rate decrease at the December 2020 meeting, depending on economic developments.
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.