Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
To engineer an economic “soft landing,” Federal Reserve monetary policy must be tightened at just the right time and just enough to avoid an overheating economy without triggering a recession. The Fed has accomplished this feat only one time since it was established in December 1913, nearly 105 years ago. The current economic expansion is on month 111, which is the second-longest economic winning streak. The longest period of continuous economic expansion ran for 120 months, from March 1991 to March 2001, which ended with the collapse of the speculative dot-com bubble. The Fed tightened policy rates five times from May 1999 to May 2000 and the federal funds interest rate went from 4.75 percent to 6.00 percent.
While the age of an economic expansion isn’t necessarily the reason for its demise, the longer the expansion runs the more vulnerable it becomes to potentially serious conditions. Often, the end of the expansion is coupled with rising monetary policy rates and some type of shock to the financial system or collapse of an asset bubble. Examples of these shocks, which we’ve seen over recent decades, include the subprime mortgage crisis, the bursting of the dot-com bubble and an oil price shock.
When a bubble bursts and the stress comes, unemployment typically increases, which starts a cycle of falling consumer confidence leading to more unemployment as demand weakens further. After a time, the Federal Reserve steps in and tries to revive the economy with accommodative monetary policy and a new economic expansion is born.
Where are we today in the business cycle? Unemployment is near the cycle lows in 2000 and 1969. Consumer confidence is the highest it’s been since early 2004 and is within a few points of reaching the highs of January 2000. Wages are growing at a moderate pace while inflation has been trending higher over the past few years.
Many would believe we are nearing the end of the current cycle, especially as the Fed keeps pushing interest rates higher, but they are unable to identify the particular catalyst that will push the economy into contraction.
Consumer debt is reaching levels not seen since the last major mortgage crisis, but the mania that drove home prices higher does not seem to be as pervasive. Stock market valuations are a concern for some, while trade worries and global economic growth are other potential triggers.
For now, the New York Fed says the probability of a recession within the next 12 months is under 15 percent. Their assessment is based on the slope of the Treasury yield curve, which is determined by taking the difference between the 10-year yield and two-year yield. Every time this difference has turned negative in the post-World War II era, a recession has followed within a few months to a year, or so.
In the meantime, many of the major economic and financial market themes we mentioned last quarter remain in play, while economic fundamentals remain solid. Real gross domestic product finished Q2-2018 at a 4.2 percent growth rate and the outlook for Q3-2018 also looks strong, likely in the 3.2-3.7 percent range. The medium-term outlook has growth slowing as the benefits of tax legislation continue to fade.
The unemployment rate is currently 3.9 percent and non-farm payrolls have grown by a monthly average of 192 thousand for the past six months. The unemployment rate is projected to gradually decline, possibly decreasing to 3.5 percent by next summer.
Inflation rates have been trending higher over the past several years, but the year-over-year consumer price index declined to 2.7 percent in August from 2.9 percent in July. This is due to prices stabilizing over the last few months as the growth in housing costs and commodity price increases have slowed. Year-over-year consumer inflation metrics are expected to trend lower, provided there are no significant price shocks.
Trade considerations remain a concern, but tensions between the U.S. and several trading partners have eased, particularly with Mexico and Europe, and people are hopeful an agreement with Canada can be reached. Trade relations with China remain strained and it does not appear any significant progress has been achieved thus far.
View on Interest Rates
The increase in U.S. Treasury yields since the beginning of the year has been moderate, with the two-year yield up about 94 basis points to 2.83 percent while the 10-year has increased nearly 65 basis points to 3.05 percent. Short-term rates continue to be driven by anticipated Federal Reserve monetary policy while longer-term rates respond to inflation expectations, the economic growth outlook, equity market volatility and geopolitical events. The consensus forecast has the two-year U.S. Treasury yield finishing 2018 near 2.95 percent, as the Fed continues to push short-term rates higher. The 10-year yield is expected to end 2018 near 3.18 percent as market uncertainty remains elevated and investors worry over rising inflation and trade tensions. A year from now, look for the two-year yield to be around 3.30 percent with the 10-year near 3.50 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 who provided the source material as well as those who 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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