Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
Since the end of June, U.S. Treasury yields have declined. The two-year yield is down four basis points to 0.61 percent while the 10-year yield is down 31 basis points to 2.04 percent. Market uncertainty has pushed volatility higher as the Chinese devalued their currency, global equity markets have corrected, Federal Reserve monetary policy remains uncertain and oil prices are near six year lows. Meanwhile, the dollar is the strongest it’s been against the euro since late-2003, the yen since mid-2007 and the Canadian dollar since mid-2004. A year ago, the two-year was yielding 0.53 percent and the ten-year yield was 2.43 percent. What is causing rates to stay low and why are monetary policy, economic growth and geopolitical events important?
Interest rates, expressed in terms of yield on U.S. Treasuries, remain low for multiple reasons. First, inflation rates are low and the expectation is for consumer prices to remain near or below 2.0 percent for the next few years. So the additional yield investors require to offset the threat of inflation is limited. Despite experiencing strong second quarter growth, gross domestic product is up 2.7 percent on a year-over-year basis as the weakest recovery in the post-World War II era continues. Monetary policy rates have been near zero since late-2008 and the Federal Reserve has increased the money supply from $750 billion to $4.5 trillion. Finally, while growth is moderate, the U.S. economy is perceived to be one of the strongest and most stable places to invest. When other parts of the global market experience upheaval and turmoil, capital flows to the safety of the U.S. Treasury market. This increases the demand for Treasury securities and pushes yields lower. During these times, return of principal is more important than return on principal.
Monetary policy is important because it has an impact on short-term rates and can influence the value of the dollar. Currently, the European Central Bank and the Bank of Japan are engaged in significant efforts to spur economic growth through low rates and large-scale quantitative easing. This has weakened the value of their currencies compared to the U.S. dollar. At the same time, the Federal Reserve is looking to tighten monetary policy rate which tends to strengthen the dollar. This 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 is reduced. While the stronger dollar is a drag on economic growth, it makes imports cheaper and may be a break-even proposition on a macro basis.
Over the past several months shorter term interest rates have had an upward bias as members of the Federal Open Market Committee have said they expect to begin hiking rates before year-end. Many analysts expected the Fed to hike rates in September, but the committee decided to leave rates unchanged, citing recent global economic and financial developments. This was likely a nod to market turbulence from a meltdown in Chinese equities and the ripple effect on both domestic and global stock markets, coupled with persistent low inflation. Consequently, it didn’t seem like a good time to reduce market liquidity. However, there are only two more meetings this year, October and December, and the market sees the probability of a rate hike this year at less than one-in-three.
Financial market uncertainty has raised fears that global growth may not be as strong as was earlier thought. However, U.S. growth has been stronger-than-expected. This is largely driven by the strength of consumer spending, which accounts for about 70 percent of U.S. GDP. Consumer confidence surveys have moved higher, personal balances sheets have improved and lower gas prices have translated into stronger auto sales and home buying.
Two items that can impact consumer confidence are equity markets and employment. While the recent stock market correction has the potential to negatively impact economic growth, we have yet to see a meaningful fall-off in consumer confidence. In the meantime, the September jobs report was much weaker than projected. If the labor sector begins to struggle we could see a pullback in spending and a slowing in the economy on weaker demand. Watch the consumer confidence surveys for potential signs the American consumer is preparing to curb spending.
Geopolitical concerns include the ongoing fight against ISIS and the resulting refugee crisis with Syrians fleeing to Europe. Now we have an open alliance between Russia and Syrian President, Bashar al Assad, to fight ISIS. There have been reports of Russian jets bombing Islamic State militants, but some areas hit have little or no ISIS presence. Look for increased oil output from the Middle East region as it appears Iran has secured a nuclear deal, which includes a lifting of sanctions. Greece has moved to the back burner and the imminent threat of default has subsided as concerns regarding Brazil’s financial stability have come to the forefront.
View on interest rates
Market volatility remains elevated as uncertainty seems to have intensified. The European Central Bank and Bank of Japan are continuing with quantitative easing and emerging market economies are looking to stimulate growth by lowering policy rates. Look for the dollar to hold on to its gains. The threat of weaker employment and economic growth are a growing concern while inflation remains contained. Another month of anemic job growth and continued declines in the equity market may delay a Fed hike in rates until early 2016.
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 2015 near 1.00 percent with the ten-year yield near 2.4 percent.
Risks to this economic outlook include a strengthening dollar depending on when and to what degree the Fed tightens rates, which may slow growth and possibly push the economy into recession. The risk of default by emerging market economies is on the rise. A continued loss of momentum by the Chinese economy could further weaken global markets and liquidity.
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