Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
U.S. Treasury yields are near the bottom of their one-year trading ranges with the two-year yield at 0.58 percent compared to a high of 1.09 percent in late-December and a low of 0.54 percent about a year ago. The 10-year is yielding 1.47 percent, which is up from a multi-year low set earlier this week at 1.44 percent while the high 2.46 percent occurred in mid-July last year. The latest event to push yields lower was the unexpected passage of the referendum by the citizens of the United Kingdom to leave the European Union. Equity markets in Europe and North America dropped sharply while the U.S. 10-year Treasury yield fell over 30 basis points in two days as investors sought the safety of U.S. Treasury securities.
Since the vote, challenges have emerged as leadership in Scotland is working to prevent the referendum from become a reality, and there are numerous petitions in Britain being circulated calling for a second vote. Parliament is obligated to respond to petitions with more than 100,000 signatures, but is not required to follow the directive of the petition. Additionally, Parliament is not obligated to follow the results of the Brexit vote, however the ruling Conservative Party may find itself in an awkward position should it choose not to respond. UK policymakers appear to be in no hurry to trigger Article 50, which starts the negotiations for the UK to officially exit the EU, while EU leadership is pressing Parliament to quickly invoke article 50. Complicating matters, Prime Minister Cameron resigned following the vote, and in recent days some leading champions of the “exit the EU” crowd have said they do not plan to run for leadership. In the meantime, the pound sterling has taken a beating and the Bank of England recently said it may need to consider a cut in monetary policy rates and other measures as UK growth is expected to slow in coming months. These factors caused both Fitch and Standard & Poor’s rating agencies to downgrade Britain to AA, from AA+ and AAA respectively. They also warned that further downgrades may follow depending on how future events develop. Nevertheless, until Article 50 is invoked the UK remains part of the EU.
For the time being, it appears the UK will remain in the European Union and investors seem optimistic that policy makers are committed to limiting the disruption. Equity markets have recovered most of the losses following the announcement of the results. The sentiment that drove the results of the referendum will likely not go away anytime soon and is indicative of a growing divide between Brussels and several member states. It’s possible that Brexit will end up being a catalyst for future realignments. EU leadership acknowledged the divide in its post-referendum statement, and renewed its commitment to “make the EU work better for all our citizens.” As we’ve witnessed over the past few years, geopolitical events continue to drive financial markets, which will likely be the reality for the next several years.
Elsewhere on the geopolitical front, options traders are betting China’s economic slowdown remains a major unresolved risk for emerging markets. According to the IMF, China continues to struggle to maintain a long-term growth rate of 6.5 percent while keeping a growing debt burden from choking off economic growth and limiting productivity gains. Policymakers are working to balance monetary support against controlling the level of credit growth, excess capacity and financial sector risk.
Adding to market uncertainty is central bank activity, which includes signals from the Federal Reserve that it wants to tighten monetary policy while the European Central Bank expands debt purchases and talks about negative policy rates. Meanwhile, the Bank of Japan is now including equity investments in it quantitative easing purchases and investors worry the Peoples Bank of China could implement more currency devaluations in an effort to quell capital outflows and stabilize their financial markets.
Looking ahead, there are four more Federal Open Market Committee meetings in 2016 with the next one scheduled for July 26-27. Fed funds futures are indicating virtually no chance of a rate hike this year as event risk continues to influence Federal Reserve sentiment. In November, we have a U.S. Presidential election, which usually has a limited immediate impact on markets, but can influence interest rates as policies of the new administration begin to be implemented. Significant European elections slated for 2017 include France in May and Germany in August.
Despite being faced with numerous event risks (Brexit, oil shocks, currency devaluations, etc.) the U.S. economy remains relatively resilient to external shocks. Real GDP growth for Q1 was initially reported at an anemic 0.5 percent, but as more data became available the final tally indicated the economy expanded at an annual rate of 1.1 percent compared to Q4-2015. Economists are projecting growth of 2.0-2.5 percent for Q2 and the second half of the year. Housing has provided a lift to economic activity along with consumer spending while excess inventories from last year and business spending has been a drag on growth. Look for a moderate uptick in inflation and continued, albeit slower, gains in employment.
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 0.85 percent with the 10-year yield near 1.8 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.
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