Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
U.S. Treasury yields have been trending higher over the past couple weeks on better-than-expected growth in the manufacturing sector, increases in oil prices, more hawkish commentary from the Federal Reserve, increased optimism by equity markets over potential tax policy reforms, and an easing in sabre rattling by North Korea. Today, yield on the two-year Treasury security is trading near 1.49 percent while the 10-year yield is about 2.33 percent. In the meantime, investors are watching the horrific news of the mass shooting in Las Vegas.
Over the past six months, the trading range for the two-year yield is 1.16 to 1.49 percent as expected increases in policy rates by the Federal Reserve push yields higher. For the 10-year yield, the range is 2.04 to 2.42 percent, with the low occurring earlier in September on elevated uncertainty related to threats made by the North Korean government while people were assessing the damage from Hurricane Harvey and watching Hurricane Irma form. However, the yield started climbing after Congress agreed to suspend the debt ceiling until mid-December and approved a $15 billion hurricane relief package.
On Sept. 19 and 20, the Federal Open Market Committee (FOMC) met to consider the condition of the U.S. economy and to set monetary policy. In a post-meeting statement, the committee indicated they believe the labor market continues to strengthen as job gains have been solid and unemployment remains low. Economic activity has been expanding at a moderate pace as household and business spending continues to fuel growth.
Year-over-year overall inflation and core inflation, which excludes volatile food and energy prices, have declined this year and remain below the Fed’s 2 percent target. Federal Reserve officials believe higher gas prices from the aftermath of hurricanes may temporarily exert upward pressure on consumer prices. Nevertheless, “inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term,” but stabilize around the committee’s 2 percent objective over the medium term.
Some economists believe it will be difficult for inflation to gather any meaningful momentum due to excessive debt loads, the demographics of an aging population, technological innovations and global competition. It may take much longer for inflation to reach the Fed’s target, which will compound the policymaker’s current efforts to remove accommodation. When we do finally see inflation push higher, it will likely be related to escalating wage pressures.
The FOMC decided to leave monetary policy rates unchanged based on the view of moderate growth with gradual gains in employment and expectations that the Fed’s inflation target will be achieved in the medium term. However, forecasts provided with the statement indicated a 25 basis point increase in rates is possible by year-end with the potential for three or four 25 basis point rate hikes next year.
Currently, the Fed is reinvesting all proceeds from maturing investments from its balance sheet. Starting in October, the FOMC will embark on “balance sheet normalization,” which means the Fed will gradually reduce the reinvestment of maturing securities and we will see the size of their investment portfolio begin to decline. The rate of reduction will be gradual in the beginning, but is expected to reach $50 billion per month over the next several quarters.
From a global perspective, the Federal Reserve’s balance sheet of $4.5 trillion in assets is the fourth largest. The Peoples Bank of China is number one with $5.2 trillion in assets followed by the European Central Bank at $5.1 trillion in assets and the Bank of Japan at $4.7 trillion in assets. The Fed is the first major central bank to announce an unwinding of its quantitative easing programs. The other central banks are continuing to add to their positions to the tune of $300 billion a month or $3.6 trillion over the next 12 months. The ECB may be the next central bank to announce plans to taper their stimulus program.
The U.S. economy expanded in Q2 by 3.1 percent compared to weaker growth of 1.2 percent for Q1. Due to the destruction caused by Hurricanes Harvey and Irma, look for increased variability in growth forecasts as economists learn more about the extent of the damage. In general, look for weaker GDP reports for Q3 and Q4 followed by a rebound in economic activity during the first half of next year.
Based on information gathered so far, the Federal Reserve Banks for New York and Atlanta are projecting Q3 growth of 1.6 percent and 2.1 percent, respectively. The expected decline is driven by a downshift in consumer spending. In addition, the New York Fed is forecasting Q4 growth of 2.0 percent. Economists see 2018 GDP growth of 2.0 to 2.5 percent.
The sustainability of consumer spending is a concern as revolving consumer credit is closing in on the $1.0 trillion mark while the savings rate is in decline. The 2015 personal savings rate was 6.0 percent. It fell to 4.9 percent for August 2016 and again to the current level of 3.6 percent for August 2017. Some analysts speculate the growth in consumer spending has been propped up by the expansion of credit and consumers tapping their savings accounts.
The average growth in consumption (consumer spending) was 3.6 percent in 2015 and 2.7 percent in 2016. These percentages exceed the five-year average of 2.4 percent and 10-year average of 1.7 percent. Without a meaningful increase in wages, the growth in spending is likely not sustainable. This would not bode well for the economy as consumer spending accounts for about 70 percent of U.S. GDP. A major pullback in spending could push the economy into an economic soft patch or some version of a recession.
The National Bureau of Economic Research dates expansions on a monthly basis. The current period of expansion is going on 99 months, which is the third-longest period without a recession during the post-WWII era, spanning 11 business cycles. While signs indicate continued modest growth ahead, the expansion in consumer credit, a declining trend in the savings rate, the potential weakening in consumer spending, and ever-increasing burden of Federal, state and local debt remains worrisome.
Next week, we will get updates on the employment situation and national manufacturing. The next FOMC meeting is scheduled for Oct. 31 and Nov. 1.
View on Interest Rates
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 2017 near 1.60 percent with the 10-year yield near 2.55 percent.
For now, the risk of recession within the next 12 months seems modest, likely in the 10 to15 percent range. However, the sustainability of current fundamentals are in question somewhat. Remain alert for potential triggers of an economic downturn, which could push longer-term rates below short-term rates, resulting in an inverted yield curve. In the past, U.S. Treasury yield-curve inversions have preceded recession.
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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