January 08, 2019
Policy, Politics and the Outlook for 2019
Lawry Knopp, VP-Funding & Hedging
Jan. 4, 2019 – U.S. Treasury long-term yields have taken a downturn over the past few months as the equity markets remain volatile, while the Federal government partial shutdown continues. It appears there is limited urgency on the part of politicians to come to an agreement on a budget deal. The 10-year Treasury yield is trading at 2.65 percent, the lowest it’s been in nearly a year. The major U.S. equity indexes have been in decline since early October with the S&P 500 composite index down about 14 percent. The prospect of a global slowdown, ongoing trade tensions between the U.S. and China, a Federal Reserve that’s signaling more rate hikes to come and continued political wrangling between Democrats and the President has given the markets much to fret over. Elsewhere, the dollar is holding on to recent gains and oil is seeking a bottom as the price of WTI crude is around $48 per barrel, the lowest it’s been since August 2017.
In the past, we’ve talked about how difficult the Federal Reserve’s job is. Policymakers must tighten monetary policy at just the right time and just enough to head off an overheating economy without triggering a recession. When Federal Reserve officials believe the economy is in jeopardy of growing too fast they set to work to engineer a “soft landing” using various monetary tools. More often than not, recessions occur near the end or shortly after a Fed tightening cycle.
Investors and traders fear the current Fed may be in the process of making another policy mistake and the risk of recession is rising. The Federal Reserve has hiked rates nine times, and 225 basis points, since late-2015 and the Fed continues to reduce its balance sheet. Both actions work to tighten financial conditions and represent a more restrictive monetary policy. Despite signs of slowing economic growth and a weaker inflation outlook, at its December meeting the Fed indicated plans for two rate hikes in 2019 and one in 2020.
Some analysts fear future rate hikes will not be based on incoming data, while others are concerned the Fed is not correctly assessing the impact of policy actions over the last few years. However, in a recent speech, Fed Chair Jerome Powell said policymakers are “prepared to adjust policy quickly and flexibly and to use all of our tools to support the economy should that be appropriate to keep the expansion on track.” He went on to stress there is “no preset path for monetary policy.” We will need to wait and see if his comments are able to quiet market concerns.
For now, the New York Fed says the probability of a recession within the next 12 months is nearly 16 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 3-month yield. Every time this difference has turned negative, resulting in a yield curve inversion, a recession has followed within six to18 months. We have also seen the equity markets flash recession warning signs as the S&P 500 index fell 20 percent from its Sept. 20 high to a cycle low on Dec. 24. Others place the probability of a recession at closer to 50 percent for 2019 and 75 percent for 2020.
The 2019 outlook calls for economic growth to moderate as the economy contends with multiple headwinds. Gross domestic product will likely downshift to a growth rate of 2.3 to 2.8 percent in 2019, which is weaker than 2018’s projected 2.9 percent growth rate. Business spending was weaker during the second half of 2018 while residential investment (housing) has been struggling due to higher mortgage interest rates. Other headwinds include weaker global growth and trade, a stronger dollar, high debt levels, less monetary stimulus and political wrangling in Washington, D.C.
Meanwhile, the labor sector is expected to show gradual improvement over the next few months, however labor tends to lag economic activity. The unemployment rate ticked up 0.2 percentage points in December to 3.9 percent, largely due to folks coming back into the workforce as the labor participation rate increased from 62.9 to 63.1 percent. Meanwhile, non-farm payrolls have averaged over 220,000 per month for the past six months. The five-year average is just under 210,000 per month.
In a sign the labor market is currently in decent shape, weekly claims for jobless benefits remain below 250,000. Furthermore, the number of job openings continues to exceed the number of unemployed. Look for the unemployment rate to gradually decline, possibly decreasing to 3.5 percent by summer, depending on growth in the labor force and household employment. However, if economic weakness does take hold and consumer confidence falls, jobless claims can be expected to increase and job growth will decline.
Key components of inflation include labor, energy and housing costs. Wage growth and housing costs are rising at about 3.0 to 3.5 percent, on an annual basis, while energy prices have fallen significantly over the past several months. Look for the decline in energy prices to partially offset rising labor and housing costs, which likely translates into a consumer price rate for inflation of 2.25 to 2.50 percent for 2019. The core rate of inflation, which excludes food and energy prices, is expected to show similar readings. Core personal consumption expenditures, the Fed’s preferred inflation metric, is projected to be around 2.0 percent for 2019.
The fundamentals of the economy are signaling a pullback in activity with storm clouds on the horizon. GDP, the jobless rate and consumer inflation are lagging indicators. Leading indicators include the Federal Reserve manufacturing and business surveys, consumer confidence readings, retail sales reports, weekly jobless claims updates and housing data. The car sales report and corporate earnings reports also provide indicators of market sentiment. Except for weekly jobless claims, most of the leading indicators have started to struggle over the past few months.
On the geopolitical front, the eurozone has plenty to deal with, including issues related to Brexit, Italian deficit spending levels that exceed European Union limits, excessive debt levels in its banking system, European Parliament elections and slower growth projections. Despite the economic weakness, the European Central Bank has ended its quantitative-easing debt purchases program. There is the potential for civil unrest related to fiscal and tax policy and a general sentiment of fragmentation among member countries. European Parliament elections will be held in May, which could change the political landscape.
While North Korea and its nuclear weapon capabilities have slipped to the back burner, recent comments by its leaders indicate this issue could get more attention in 2019. Asia’s economic situation is impacted a great deal by the performance of China’s economy. Recently, there have been signs that China’s economy is losing momentum, which does not bode well for the region.
View on Interest Rates
The Federal Reserve has indicated its intention to be cognizant of the impact of monetary policy on the economy and to adjust as they deem necessary. Nevertheless, the Federal Open Market Committee indicated in December plans to hike interest rates in 2019 and possibly in 2020. The Federal funds futures are currently indicating a less than 5 percent chance the Fed will increase rates in 2019. In fact, there is a 25 percent probability of a rate cut at the Dec. 11, 2019 meeting. These probabilities move on a daily basis and you can get a feel for what the market is thinking at the CME FedWatch Tool website: https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html/.
Until the two opposing views on the outlook for the economy by the Fed and the market consolidate, look for Treasury yields to remain near current levels with periods of elevated volatility. Other factors to consider include what impact a resolution to the government shutdown impasse will have on the economy and what circumstances will be needed for the equity markets to stabilize and brighten the economic outlook.
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.