Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
U.S. Treasury yields are up about 30 to 40 basis points since the U.S. Presidential election on Nov. 8, 2016. The two-year yield, at 1.23 percent, is down from a seven-year high of 1.28 percent on Dec. 15, the day after the Federal Reserve increased monetary policy rates. The 10-year yield is at 2.45 percent, which is down from 2.60 percent on Dec. 15, the highest the 10-year yield has been since September 2014.
Yields moved up following the election as equity markets rose in anticipation that President-elect Donald Trump would work to implement pro-growth policies. Also pushing yields higher was the expectation the Federal Reserve would increase short-term interest rates at its December Federal Open Market Committee meeting. Despite terrorist attacks in other countries and a somewhat rocky transition from the Obama administration, market sentiment and optimism have remained positive and the major equity indexes have hit new all-time highs since the election.
Many questions surround the ability of the Trump administration to implement its policies on trade, tax reform, infrastructure spending and government regulation. Much will depend on the amount of cooperation the administration receives from the GOP-led House and Senate and obstacles from the Democratic opposition. Nevertheless, markets are likely in for a bumpy ride in 2017. It will take time to effect change in government programs; rising interest rates and a potential equity market correction could threaten investor confidence and stagnate consumer and business spending.
Over the past few months we’ve seen the risk of recession fade, with the November analysis from the New York Fed indicating there is a 5.5 percent chance of a recession over the next 12 months. Others place the chance of a recession a little higher simply because the current expansion, now at 90 months, is well past the post-WWII era average of 69 months. The longest expansion, dating back to the 1850s, was 120 months, which occurred between March 1991 and March 2001. Furthermore, over the past 100 years, the U.S. economy has either been in a recession or entered a recession within a year following the end of a two-term presidency. While the risk of a recession is currently low and will likely not occur this year, history would indicate the Trump administration should be prepared for an economic downturn within the next 12 to 24 months.
While we’re on the subject of economic growth, we recently received the final report on Q3 real Gross Domestic Product and we saw a nice bounce in the economy for the quarter. Economic activity expanded by 3.5 percent, the best quarter since Q3-2014, with business spending, inventories and net exports contributing to growth. Consumer spending provided most of the inertia. Also, for the second quarter in a row, the housing sector was a drag on growth. Compared to a year ago, however, economic activity is up 1.7 percent.
GDP growth for Q4 is projected to be weaker, at about 2.0 percent, which would mean the economy grew by 1.6 percent in 2016. The forecast for 2017 is calling for real GDP growth of 2.0 to 2.3 percent. As the Trump administration gets underway there will be no shortage of policy uncertainty as the administration contends with excessive debt loads, less accommodative monetary policy and burdensome regulation as it works to implement changes to tax policy, adjust trade policy and expand infrastructure spending and jobs.
The November employment report from the Bureau of Labor Statistics indicated the unemployment rate fell by 0.3 percentage points to 4.6 percent, the lowest it’s been since May 2007, as employment rose and the labor force declined. This was a large drop and likely an anomaly as the market is looking for a 0.1 or 0.2 percentage point increase in the December jobless rate.
Despite the labor force participation rate being near 30-year lows and the number of folks not in the labor force exceeding 95 million, weekly claims for jobless benefits continue to average 260,000, a level that typically indicates an improving labor market. Economists are looking for the unemployment rate to gradually move down to 4.4 percent later this year.
In July 2016, year-over-year consumer price inflation was 0.8 percent, but as energy prices stabilized and low energy costs from a year ago move out of the rolling average base, CPI has now risen four months in a row. Economists see year-over-year CPI running at 2.2 to 2.6 percent for 2017 as the inflation rate for services such as medical care and housing costs exceed 3 percent. Look for consumer price inflation to range from 2.0 to 2.5 percent for the next couple years.
In December, the FOMC increased the target range for monetary policy rates by 25 basis points to 0.50 to 0.75 percent. Based on current conditions of modest growth, moderate inflation and continued gains in employment, the market is expecting two 25-basis-point rate hikes in 2017 with the first increase sometime this summer and then again near year-end.
While the U.S. economy is relatively resilient, it can be influenced by geopolitical events that can threaten global financial market stability. However, turmoil tends to push U.S. rates lower as investors seek the safety of U.S. Treasury securities and central banks add liquidity to calm markets. Potential threats to market stability include elections in France and Germany, ongoing extreme measures by foreign central banks to stabilize their economies, renewed sovereign debt concerns involving Greece and Italy and terrorism and turmoil in the Middle East.
View on Interest Rates
Short-term rates continue to be driven by anticipated Federal Reserve monetary policy while longer-term rates respond to inflation, economic growth, equity market volatility and geopolitical events. The consensus forecast has the two-year U.S. Treasury yield finishing 2017 near 1.75 percent with the 10-year yield near 2.75 percent.
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