Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
The level of interest rates essentially reflects the economic outlook of investors and traders. The primary factors that influence their view include projections for economic growth, which is usually expressed as real gross domestic product, inflation and employment. Real GDP is gross domestic product adjusted for inflation. Other contributing factors include monetary and fiscal policy, geopolitical events and the level of uncertainty in the markets.
We recently got the final report on Q4-2015 growth, which indicated the economy expanded by 1.4 percent. This was down from 2.0 percent in Q3 and 3.9 percent for Q2. Official reports indicate real GDP grew by 2.4 percent for 2015. We won’t get our first look at Q1-2016 growth until late next month and consensus projections indicate growth will be in the 1.5 to 2.0 percent range.
Economic headwinds that contributed to lackluster growth for 2015 are expected to remain in play for 2016. It appears that oil prices bottomed in mid-February and dollar strengthening was halted as we saw it weaken to near one-year lows in February and March. Other indicators have seen limited improvement as foreign central banks continue to expand monetary easing while others continue selling reserves to prop up their currencies and economies. Meanwhile, corporate profits were lower for 2015 compared to 2014 and were on the down escalator for both Q3 and Q4.
Unfortunately, it looks like there are few economic tailwinds to provide a surge in growth. Recent reports on leading indicators for consumer spending and capital investment have been unexpectedly weak while gains in housing continue at a modest pace. Look for 2016 growth of 1.8 to 2.3 percent.
On March 16 the Federal Reserve decided to leave the Federal Funds rate target range unchanged at 0.25 to 0.50 percent. Back in December, the Federal Open Market Committee increased the range by 25 basis points based on continued improvement in labor conditions and confidence that inflation would rise over the medium-term to the Fed’s 2 percent target.
Lately, the market has received some mixed signals from the Federal Reserve as comments from Fed Presidents hinted that an increase in policy rates was right around the corner, driving yields higher. However, yields began to retreat following a recent speech by Federal Reserve Chairwoman, Janet Yellen, which calmed market fears of an impending rate hike. Federal Funds futures put the chances of a rate hike by June at one-in-five.
Year-over-year consumer price inflation has remained below 2.0 percent going back to June 2014 and below 3.0 percent since January 2012. It currently stands at 1.0 percent. The primary driver of recent declines has been low oil prices while falling home prices helped push inflation lower in 2010 and 2011. A key measure of inflation is the so called core rate of inflation, which excludes the volatile food and energy components. While overall inflation has been benign over the past 12-18 months, core inflation has been on an upward trend, currently at 2.3 percent. Stable prices are one of the dual mandates acknowledged by the Fed with full employment being the other. While oil prices remain low and housing gains are moderate, look for headline inflation and core inflation to converge near 2.0 percent over the next couple years.
The unemployment rate for March increased 0.1 percentage points to 5.0 percent while nonfarm payrolls grew by 215,000. Labor conditions have steadily improved over the past few years and the unemployment rate has fallen from 10.0 percent back in October 2009. During this time, the labor force participation rate also moved lower as folks left the workforce. Some of this was from retirements while others found it difficult to return to the workforce after losing their job in 2007 and 2008. The current participation rate is 63.0 percent, a six-month high.
Over the past six months, job growth has averaged nearly 250,000 per month while the labor force has grown by 2.4 million. At the same time, weekly earnings have increased only 1.7 percent. On the surface the low unemployment rate and growth in payrolls look good. However, the Federal Reserve interprets the weaker gains in wages and a growing labor force as slack in the labor sector, which means they will likely be tolerant of rising inflation, especially if it comes from stronger wage growth.
Geopolitical events can generate financial market turmoil. This often causes investors to seek the safety of the U.S. Treasury market, driving yields lower as they seek a return of principal over a return on principal. Over the next few months look for oil prices to influence global economic market conditions. Continued oversupply is worrisome and while the price of oil may have found a bottom, significant supply issues have yet to be fully addressed.
The prospect of Britain exiting the European Union continues to gain traction, which has weakened the pound against most major currencies. A referendum is scheduled for June 23 of this year.
View on Interest Rates
In summary and looking back at our primary drivers of interest rates, economic growth is expected to be modest and exert limited upward pressure on rates as the economy is nowhere near overheating. From an inflation perspective, low energy prices are currently holding down increases in consumer prices, but gains in food, housing and other items will likely push inflation to the 2.0 to 2.5 percent range over the next year or two. The Federal Reserve and the economy can tolerate moderate inflation for a time and should generate only minimal upward pressure on rates. While the unemployment rate remains near cycle lows, underlying weakness in wage growth will likely not be a source of inflationary pressures.
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 1.3 percent with the ten-year yield near 2.4 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.