Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
U.S. Treasury yields are well inside their one-year trading ranges with the two-year yield at 0.76 percent compared to a high of 1.09 percent in late-December 2015 and a low of 0.55 percent in October 2015. The 10-year is yielding 1.60 percent, which is up from a multi-decade low of 1.36 percent set in early-July while the high of 2.34 percent occurred in November last year.
We recently received the final report on Q2 real gross domestic product and the first half of the year was nothing to write home about. The U.S. economy eked out a 1.1 percent growth rate with housing providing a boost for Q1 while consumer spending led the way during Q2. Business investment and excess inventories have been a drag on growth over the past three quarters. Some of the weakness is due to weaker profits as the energy sector adjusts to $40-$50/barrel oil while other businesses dependent on exports acclimate to the strong dollar.
Looking ahead, “as the consumer goes, so goes the economy,” with consumer spending accounting for about 70 percent of all economic activity. Consumer spending grew by 4.4 percent during Q2, with some of the growth likely robbing from future quarters as auto sales contributed nicely. This probably will not be repeated during the second half of the year, so look for consumer spending to fall off to the 2.5-3.0 percent range and overall real GDP to be around 2.25-2.75 percent as inventories are less of a drag, housing activity remains sluggish and business investment likely takes a wait-and-see stance until after the election.
The economy is on track for 2016 growth to come in around 1.5 percent with the forecast for 2017 calling for real GDP growth of 1.7-2.2 percent. Major themes impacting growth are excessive debt loads, monetary policy, regulation and demographics.
Chatter about when the next recession will occur has picked up. One of the most accurate predictors of recessions has been the yield curve. When the yield curve inverts, meaning the three-month Treasury yield is higher than the 10-year yield, for example, a recession typically soon follows. The New York Fed places the odds of a recession within the next 12 months, based on the current shape of the curve, at about one in 10.
Labor force participation remains near 30-year lows while the number of folks not in the labor force is hovering around 94 million, which could trend higher. Some of this is due to demographics as baby boomers started turning 65 in 2010. The number of baby boomers turning 65 each day is about 10,000 and this will continue for another 15 years.
Non-farm payrolls are growing at about 200,000 per month while the unemployment rate has been 4.9 percent for the past three months. Average hourly earnings are growing at 2.4 percent, which is better than the 2.3 percent growth rate for the past 10 years. Despite the structural issues, look for continued gains in the labor sector as weekly claims for jobless benefits continue to run near 260,000. Weekly claims have been below 300,000, a level that typically signals improving labor market trends, for 82 consecutive weeks, which has not occurred since 1970. The unemployment rate is expected to move down to 4.7 percent by the end of 2017. Job growth may slip from 200,000 per month to 175,000 per month on modest economic growth.
Over the past few years, inflation has been modest with housing and low wages exerting significant downward pressure on overall consumer prices starting in 2008. As home prices began to recover, the drop in energy prices in 2014 and 2015 offset the rising cost for housing. Home sale prices are growing at about 4-5 percent per year and oil prices appear to be stabilizing in the $40-$50/barrel range. Look for consumer price inflation to range from 2.0-2.5 percent for the next couple years. Once we see inflation exceeding these ranges, the Federal Reserve will likely get serious about tightening monetary policy rates.
Despite an economy growing at 1.5 percent, manufacturing currently showing signs of contracting and modest inflation, recent speeches by several Federal Reserve officials indicate they would support a rate increase by year-end. In September’s Federal Open Market Committee meeting, three voting members dissented to the decision to leave rates unchanged, instead favoring an increase. Since there are only two FOMC meetings remaining this year, if the Fed does raise rates it will likely be at the December meeting. The next meeting is Nov. 1-2 and there is virtually no chance the Fed would change monetary policy days before a U.S. presidential election.
Federal funds futures indicate about a 50-50 chance of a 25-basis-point rate hike in December. Based on current conditions, modest growth, moderate inflation and continued gains in employment, look for the next rate hike to occur sometime next year provided no geopolitical event(s) threaten(s) global economic growth. The market puts the odds of a December 2017 rate hike at about 75 percent.
While the U.S. economy is relatively resilient, it can be influenced by events affecting our major trading partners and threats to global financial market stability. Nevertheless, turmoil tends to push U.S. rates lower as investors seek the safety of U.S. Treasury securities and central banks add liquidity to calm markets.
It appears the European Central Bank and Bank of Japan are reconsidering the effectiveness of further monetary stimulus to spur growth and generate inflation. There seems to be growing concern among central bankers that continued low rates and expanding quantitative easing may be losing its effectiveness and could pose a threat to long-term financial stability. Meanwhile, the Federal Reserve continues to talk about raising rates despite underwhelming economic data.
Look for policymakers and government leaders to begin talking more about combining monetary and fiscal policy as a strategy for reviving growth. Depending on implementation, whether it’s done through changes in taxes, regulation and/or increased government spending, the result would likely be stronger economic growth, but at the cost of higher consumer inflation and rising interest rates.
There are worries over the health of the European financial sector as Germany’s largest bank, Deutsche Bank, is facing stiff fines from the U.S. Department of Justice on charges the bank packaged and sold faulty residential mortgage bonds at the heart of the 2008 financial crisis. In addition, a potential crisis is brewing as elevated levels of nonperforming assets are pressuring capital ratios for Italian banks.
LIBOR rates have moved up over the past couple months as new regulations, set to take effect on Oct. 14, impact how market risk is determined for money market funds used by institutional investors. Other individual and government-based funds do not fall under the new regulations. Some analysts believe the higher LIBOR rates are doing some of the work for the Fed as higher borrowing costs reduce market liquidity. We could see LIBOR rates moderate depending on how long it takes for the market to adjust to the new reforms.
Oil prices have been choppy as supply and demand dynamics have been unbalanced for the past 12 to18 months. We may soon see progress on restoring the balance between output and consumption provided a recent OPEC agreement to cut production for the first time in eight years is successfully implemented. Production would be capped at 32.5 million barrels a day, which is roughly 750,000 barrels less than what was produced in August. OPEC accounts for about 40 percent of global oil production.
Brexit concerns have eased, but an exit by the UK from the European Union remains a certainty. While Greece is no longer making headlines, the debt issues and questions surrounding solvency remain. Also, keep an eye on German Chancellor Angela Merkel’s reelection efforts, an Italian referendum in December that would overhaul the process of building governmental coalitions and the French presidential election to be held in April and May 2017.
View on Interest Rates
Short-term rates continue to be driven by anticipated Federal Reserve monetary policy while longer-term rates respond to inflation, economic growth, equity market volatility and geopolitical events. The consensus forecast has the two-year U.S. Treasury yield finishing 2016 near 0.95 percent with the 10-year yield near 1.9 percent.
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 that provided the source material as well as those that 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.