Treasuries are under a bit of pressure this morning after some better-than-expected data out of both China and Europe. The softness follows a week where long-end Treasury supply (10yr notes and 30yr bonds) was easily put away so perhaps some give back at the end of the week is appropriate. The 10yr is currently testing support at 2.54% so we’ll watch to see if that level holds. Later this morning we’ll get an updated read on consumer sentiment with little change expected in the University of Michigan Sentiment Index at 98.2 forecast vs. 98.4 in March. With the consumer comprising two-thirds of the economy the expected rebound in second quarter GDP will have to come primarily from increased consumer consumption and better sentiment would seem to be a necessary precursor to an uptick in spending. While we await those results, in the section below we delve deeper into the question of why yields remain so hesitant to back-up despite the resilience of the domestic economy.
We’ve been conducting a series of half-day bond school seminars over the last year and part of the presentation involves a look at our economic outlook. That outlook has generally been one that has come to pass with slowing growth and inflation dampening yields and fed funds rate expectations. It did strike us during some of the later presentations that the somewhat dour forecast contrasted with generally upbeat local lending conditions for many banks in attendance.
That dichotomy struck us again as we read the FOMC minutes from the March 20th meeting. While still waxing positive about the domestic economy, staff and Fed members expressed increasing concern over a number of factors that are more international in scope. The slowdown in Europe and China was mentioned, as was the ongoing uncertainty over Brexit in the U.K. and the E.U., and the uncertain resolution of trade negotiations with China and possible auto tariffs against the E.U. following a China deal. A flat to inverted yield curve was mentioned too as a potential risk.
In our economic presentations the slowing global growth story gets attention as does the recessionary signal of an inverted yield curve. And while an inverted curve starts the countdown towards recession, the average time between inversion and recession stretches to 15-16 months, on average. So when you combine the still resilient U.S. economy and the lag between curve inversion and recession it’s likely a late-2020 event, at the earliest. So it’s certainly possible, if not likely, that local economic conditions can appear robust even as recessionary warning signs begin to flash.
We mention this to highlight the factors driving yields lower. It seems perplexing to some in the face of solid economic and labor market expansion, and strong local lending conditions, that rates and yields should be higher, or at least heading in that direction. But with the interconnectedness of global economies and financial markets the rest of the world is providing a downdraft in yields that is hard to overcome. Everything from weak and/or weakening global economies to dollar strength have conspired to generate headwinds against greater U.S. growth while also suppressing inflation.
The question is can those risks mentioned by the Fed ease to the point that the global economy becomes less a headwind or even a tailwind to U.S. demand and growth? While the E.U. has extended the Brexit deadline to October 31 that extension merely removes the immediate risk of a no-deal Brexit that would have severely undermined all parties involved. Meanwhile, a post-Brexit world is still an uncertainty that will continue to be a drag on the U.K. and the E.U..
Speaking of the E.U., the ECB is already in ultra-accommodative mode and returning to QE programs later this year to try and boost its increasingly moribund economies—particularly Germany and France. And with President Trump threatening tariffs against Europe-made cars, the auto manufacturing-heavy economy of Germany doesn’t appear poised to rebound anytime soon. Meanwhile, Chinese officials may have greater freedom to employ easier monetary policies to reignite growth, the debt overhang and tepid global demand will continue to be hurdles to faster growth in the near-term. Thus, the headwinds mentioned by the Fed, and highlighted in our economic presentations, don’t appear to be receding soon and that will likely continue to suppress yields.
Furthermore, with the sugar-high of tax cuts and the surge in deficit fiscal spending diminishing, U.S. GDP will be returning to something closer to long-run potential of 1.8%-2.0% versus the 2.9% 2018 rate. The ability to withstand global headwinds diminishes in that environment and the Fed is no doubt cognizant of that. And while a disappointing first quarter GDP of 1.6% is expected to rebound to the mid-2% range, forecasts for all of 2019 remain closer to long-run potential of 1.8%-2.0%. That second quarter bounce implies consumer consumption rebounding after a dismal December and early 2019 performance. That may be the case but with the latest real average weekly earnings dropping to 1.3% YoY—the lowest since November—the increasing wage story just took a hit. The question is will that be a factor in diminished consumption? If so, the 2% 2019 GDP estimates may need to move lower and that is not a recipe for higher yields. Given that outlook it’s not surprising the Fed is in patient pause mode, and it’s a pause that will likely extend into 2020, and very well could mark the end of the hiking cycle. In fact, the market is forecasting a rate cut by year-end with the expectation that the domestic economy eventually succumbs to the global headwinds rather than those headwinds diminishing.
Productivity Improving But More is Needed
GDP is expected to trend lower over the next couple years to its long-run potential of 1.8%-2.0%. That downtrend is one reason the Fed is vigilant to the possibility of increasing global headwinds that could suppress growth further. Two factors largely dictate long-run GDP potential: productivity and labor force growth. The sum of the percentage increase in both factors defines GDP growth potential. Productivity over the last 30-years has averaged 2.0% and while there has been recent improvement, it still lags the average. Increasing potential GDP requires either greater productivity and/or labor force growth but that’s easier said than done and one reason most long-run GDP projections remain anchored around 2.0%.
|Treasury Curve||Today||Chg Last Wk.||LIBOR Rates||Today||Chg Last Wk.||FF/Prime||Rate||Swap Rates||Rate|
|3 Month||2.42%||+0.02%||1 Mo LIBOR||2.48%||+0.01%||FF Target Rate||2.25%-2.50%||3 Year||2.420%|
|6 Month||2.45%||+0.03%||3 Mo LIBOR||2.60%||+0.01%||Prime Rate||5.50%||5 Year||2.399%|
|2 Year||2.39%||+0.05%||6 Mo LIBOR||2.63%||-0.01%||IOER||2.40%||10 Year||2.532%|
|10 Year||2.55%||+0.05%||12 MO LIBOR||2.74%||-0.01%||SOFR||2.44%|