Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
January 4, 2016 – Goodbye and farewell to 2015, a year with a 30 percent drop in the price of oil, continued gains in the dollar and the first tightening in monetary policy by the Federal Reserve in nearly a decade. And now, hello to 2016, which will likely experience continued unrest and turmoil on the geopolitical front, more rate hikes by the Fed, higher interest rates and low oil prices.
The price of oil has gone through the worst back-to-back annual declines these past two years largely due to global economic weakness that started in 2014 while production continued to expand through 2015. On December 4, OPEC announced it was setting aside its oil production limit of 30 million barrels a day (b/d). Consequently, December output expanded to 32.1m b/d in an effort to retain market share. OPEC is made up of 13 members with the larger producers including Saudi Arabia, Iraq, Kuwait, U.A.E, Iran, Venezuela and Angola. Saudi Arabia produces as much as Iraq, Kuwait and U.A.E. combined. Ecuador and Venezuela are the only OPEC members in the western hemisphere with reported December production of a combined 3m b/d. U.S. production totals 9.2m b/d and the 40-year ban on crude oil exports was lifted last month.
Excess supply will likely continue for 2016. However, in a recent report, the U.S. Department of Energy said 2015 total world production stood at 95.5m b/d, which exceeded consumption by 1.72m b/d. In 2016, excess output is projected to decline to 0.6m b/d. With consumption projected to grow by 1.5 percent look for the gap to narrow by 1.2m b/d and the possibility of oil prices bottoming during the second half of the year.
On December 16 the Federal Reserve increased the federal funds rate target range by 25 basis points to 0.25-0.50 percent. This marked the first increase in policy rates since June 2006. The Federal Open Market Committee, which is chaired by Janet Yellen, said it was appropriate to tighten policy “given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes.” There has been “considerable improvement in labor conditions” and the committee was “reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.” At the same time, the Fed expects to maintain prior rounds of quantitative easing by reinvesting principal payments from its holdings of agency and Treasury securities. This will likely continue “until normalization of the level of the federal funds rate is well underway.”
The Federal Reserve can be responsive to market conditions and adjust policy actions in response to market developments and volatility and the rate of inflation and economic growth. Based on projections provided by the Fed, the committee expects to increase rates a total of 100 basis points during 2016 in 25 basis point increments. In addition, the Fed expects GDP growth of 2.4 percent for 2016, an improvement in the unemployment rate to 4.7 percent and the Fed’s gauge for inflation to increase from 1.3 percent to 1.6 percent. The market’s view on the timing of rate hikes is less aggressive based on federal funds futures which indicate two 25 basis point increases, the first one during the summer and the next one by year-end.
For the third consecutive year, the dollar strengthened against most major currencies. This has largely been due to increased efforts on the part of the European and Japanese central banks to stimulate their economies through quantitative easing and reductions in monetary policy rates. These actions also weakened their currencies. In addition, China engaged in outright currency devaluation, capital controls, trading restrictions and policy rate reductions to settle investor fears as Chinese equity markets were in turmoil. At the same time, the Federal Reserve was talking about tightening U.S. monetary policy. The combination of these events pushed the dollar up another 9 percent in 2015.
Look for the dollar to maintain its strength as the European Central Bank and the Bank of Japan remain engaged in significant efforts to spur economic growth through low rates and large-scale quantitative easing. The Peoples Bank of China is expected to further weaken the Yuan through monetary and fiscal policies as they work to transform to a more consumer-based economy. The stronger dollar is not good news for folks that export their goods to foreign markets as their products are more costly to foreign buyers and their competitiveness in global markets is reduced. While the stronger dollar is a drag on U.S. economic growth, it makes imports cheaper, especially for consumers and works to limit inflation, which could be a break-even proposition on a macro basis.
Other geopolitical concerns include terrorist threats from various groups, such as ISIS, continued economic weakness in Latin America, the Syrian refugee crisis and increased involvement of Russia in the Middle East. The U.S. presidential election cycle is getting more airplay, but historically has had a limited impact on markets. Although, post-election policy and initiatives can significantly impact markets, depending on the ability of the new administration to implement change.
View on Interest Rates
Look for the U.S. economy to continue to expand by 2.2 to 2.7 percent in 2016 as consumer confidence remains strong and wages gradually increase. The benefit from lower gas prices will continue to aide consumer spending and limit increases in inflation. Equity markets gains are expected to be choppy.
Short-term rates continue to be driven by anticipated Federal Reserve monetary policy while long-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 1.5 percent with the ten-year yield near 2.8 percent.
Risks to the economic outlook include an over aggressive Fed that tightens rates too quickly causing growth to stall. Global markets should be able to handle a gradual increase in rates. However, a sharp and sustained rising rate scenario will be more difficult and could bring significant pressures on margins, valuations and liquidity along with periods of extreme market volatility. Sovereign debt issues in Europe have subsided, but remain a potential source of uncertainty. The risk of default by emerging market economies remains a concern. China’s ongoing transformation has the potential to further disrupt and weaken global markets and pressure liquidity. Their desire to have a stronger military presence could also destabilize the Asian region and emerging markets.
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.
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