June 29, 2018
Monetary Policy to Turn Restrictive while Trade Tensions Temper Optimism
Lawry Knopp, VP-Funding & Hedging
Major economic and financial market themes currently in play include a nice rebound in U.S. domestic growth, a moderate acceleration in inflation, and continued gradual improvements in the labor sector. Monetary policy appears to be on track for two more rate hikes this year while the potential for a trade war between the U.S. and its major trading partners is increasingly worrisome. The global growth outlook has downshifted as the eurozone appears to be losing momentum while other geopolitical concerns (i.e., North Korea and the Middle East) have eased.
The Bureau of Economic Analysis released its final revision to Q1-2018 Gross Domestic Product, which was revised down to 2.0 percent versus the prior release at 2.2 percent. This is old news as we’ve just closed the books on Q2. The New York Federal Reserve staff are projecting the economy expanded by nearly 2.8 percent during the second quarter.
This compares to a forecast of 3.8 percent real GDP growth for Q2 from the Atlanta Federal Reserve Bank Center for Quantitative Economic Research. Reality will likely fall somewhere in the middle, likely around 3.2 percent. The stronger growth rates reflect an expected pickup in consumer spending while business spending and housing are also expected to gain momentum.
As we indicated last quarter, the economy remains near full employment with the latest reading showing an unemployment rate of 3.8 percent, which is the lowest jobless rate since December 1969. (In 2000, unemployment got down to 3.9 percent.) The skills gap continues to be an issue for employers as the ratio of hires to job openings hit a new low in March and rebounded only a touch in April. On a seasonally adjusted basis, the number of job openings is at a record 6.698 million, which surpassed the total number of unemployed of 6.065 million. The Bureau of Labor Statistics began collecting the job openings data in December 2000 and March was the first time job openings exceeded the number of unemployed. This likely means some level of wage inflation is in our future.
On a trend basis, job growth remains moderate with non-farm payrolls expanding by an average of just over 200,000 a month. A key metric to watch is the weekly claims for jobless benefits report. As long as claims remain below 250,000 we can expect continued gradual decreases in the unemployment rate. If weekly claims were to rise above 300,000, increases in the jobless rate would soon follow.
Headline inflation, expressed as the consumer price index (CPI), is up 2.8 percent compared to a year ago May. For April, the Federal Reserve’s preferred measure of inflation – year-over-year core personal consumption expenditures (PCE), which exclude food and energy prices – grew at a rate of 1.8 percent. Look for the rate of inflation to remain modest with core-PCE hitting the Fed’s target of 2 percent within the next few months. Wage growth and energy prices are key elements of the inflation complex and sharp increases in either would likely push overall inflation higher.
The Federal Reserve and Monetary Policy
In a move largely expected by the market in June, the FOMC increased its federal funds target range by 25 basis points to 1.75 to 2 percent. Commercial banks followed suit and raised the prime rate to 5 percent, the highest it’s been since September 2008. Based on recent performance of the economy, the FOMC believes the labor market continues to strengthen while economic activity is expanding at a solid rate. The committee viewed risk to the economic outlook over the medium term to be “roughly balanced” and gradual increases in policy rates will be consistent with sustained growth, strong labor market conditions and inflation near the Fed’s inflation target of 2 percent.
Based on market indications, the odds of a 25-basis point-rate hike in September are near 75 percent with about a 50/50 chance of an additional 25-basis-point rate increase in December. Furthermore, look for three rate hikes in 2019. The Federal Reserve will increase its pace of balance sheet normalization (pay down) from $30 billion per month to $40 billion per month, starting in July.
The New York Federal Reserve places the odds of a recession over the next 12 months at 11 percent, which feels a little low. As we look out over the next 24 to 36 months, it would seem the chances of a recession are higher, likely approaching 25 to 50 percent.
We are now nine years from the end of the Great Recession, which officially ended June 2009. This marks the second-longest period of expansion going back to the early 1800s. The longest expansion occurred during the 1990s from March 1991 to March 2001.
Every recession in the post-WWII era has been preceded by a string of Fed rate hikes, which causes an inverted yield curve as short-term Treasury yields exceeded long-term yields. More severe recessions typically follow some form of crisis, be it the subprime mortgage crisis in 2007-08, which lasted 18 months, or the Fed’s response to rising oil prices and inflation in 1981-82 following the Iranian Revolution, which pushed the economy into a 16-month-long recession.
Looking at other, shorter-duration recessions, the common themes are tightening regimes by the Federal Reserve as it works to bring down inflation expectations, slow an over-heating economy or deflate some form of an asset bubble. These types of recessions tend to be shorter, lasting seven to 10 months on average.
We are likely facing several more rate hikes by the Fed as the unemployment rate hits a 50-year low and inflationary pressures from rising oil prices, home values and wages appear to be building. If economic growth does not keep pace with inflation and the Fed increases interest rates, a yield curve inversion will likely occur with a recession expected shortly thereafter. In the meantime, remain alert for potential triggers of an economic or financial crisis and the potential to slow economic growth.
Thus far, it’s been difficult for the market to separate rhetoric from substance as trade friction between the U.S. and its major trading partners has escalated. Trade barriers have been in place for many years and the premise that we have free and fair trade seems to be a stretch. All the talk of tariffs is only one facet of the restrictions applied to trade and the competitiveness between what’s produced in one country versus another. A more comprehensive discussion on the topic of trade would include currency manipulation and subsidies and quota systems, which in large part have been left out of the narrative.
A resolution to the issue seems a way off yet and will likely not occur until tariffs start to take hold and trade flows, supply chains and import prices begin to be impacted. If no agreements on trade can be achieved, the outcome of a trade war at the macro level would likely be a reduction to GDP of a few percentage points or more, a moderate increase in inflation and higher unemployment. The impact at the micro level could be much more intense as some firms or sectors bear the brunt of increased tariffs and retaliation. Nevertheless, a major trade war seems unlikely, but the risks are rising and this remains a risk to the outlook.
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 65 basis points to 2.52 percent while the 10-year has increased nearly 45 basis points to 2.84 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 2.90 percent, as the Fed continues to push short-term rates higher. The 10-year yield is expected to end 2018 near 3.15 percent as market uncertainty remains elevated and investors worry over rising inflation and trade tensions.
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