Continued economic expansion and curve flattening dominate US data flow

GDPNow for the second quarter is still at a breathtakingly high 4.5%. And it’s beginning to look like we are going to come in well above 3% growth for the quarter. Consensus estimates are at 3.5%. Meanwhile the yield curve continues to flatten, with the differential between the 2-year and 10-year Treasury now below 33 basis points. The question is what to make of this. Some brief thoughts below.

Trade and immigration tensions side game

I resisted saying too much about trade and immigration over the past two weeks as those issues dominated headlines. Those issues pack a punch emotionally and politically. But economically, they aren’t going to change things significantly in the US.

Globally, trade rose from 20% of GDP in 1995 to 30% in 2014 as the world became more interconnected. The US is a continental economy with a relatively low trade percentage. But it has still become more integrated into the world economy, with trade making up 27% of GDP by 2016 versus 9% in 1960.

But if you compare the US to Germany on exports, you have a country in Germany that exported a massive 46.1% of GDP in 2016. Yes, much of that goes to other EU countries with no trade barriers. But it still leaves Germany vulnerable to a fall in external demand. Meanwhile, the US exported a mere 11.9% of GDP in 2016. That means that regardless of what happens in the ongoing trade wars, it is likely to have a small near-term impact on the US. So ignore headlines about market gyrations due to trade concerns. This is just noise. We should concentrate on domestic economic issues.

The big issues are inflation, wages and interest rates

I think the domestic economy in the US looks good. There is almost zero chance of a recession in 2018. And I wouldn’t expect recession odds to creep up until late in 2019. That’s because the labor market has tightened and wages are rising at a pace supportive of growth. You would need a huge economic shock to knock the economy off kilter.

Moreover, in the near term, rising interest rates add an acceleration to the economy via increased interest income and by pulling forward demand for credit. It’s only when higher rates create debt distress that they retard growth. And we aren’t there yet.

As yet, inflation isn’t a problem either. In fact, a recent speech by Fed Chairman Powell offered some surprisingly dovish comments regarding inflation. Take a look at the following section of his speech:

High demand for workers should support wage growth and labor force participation–the latter a measure on which the United States now lags most other advanced economies. A tight labor market may also lead businesses to invest more in technology and training, which should support productivity growth.

That’s Powell making an argument for a tightening labor market increasing productivity — which, in turn, increases output for the same cost. It’s a comment that basically says a tightening labor market has some anti-inflationary impacts.

What else did Powell say?

But Powell had more dovish comments as well. For example, thisFor example, this:

Many forecasters expect the unemployment rate to fall into the mid-3s and to remain there for an extended period. If that comes to pass, it will mean the lowest unemployment in the United States since the late 1960s.

A historical comparison
Because we have so little experience with very low unemployment, it is interesting to compare today’s labor market with that earlier period. Unemployment was below 4 percent from February 1966 through January 1970. During that time, inflation as measured by the price index for personal consumption expenditures increased from below 2 percent in 1965 to about 5 percent in 1970. In hindsight, unemployment is now widely thought to have been unsustainably low at that time and to have contributed to escalating inflation.

But how significant is this precedent for today?…

Unfortunately, with the passage of a half-century and important changes in the structure of our economy and in central bank practices, in my view the historical comparison does not shed as much light as we might have hoped.

Translation: The rising inflation of the 1960s is not a good precedent for today.

Conclusion: The Fed is still uncertain as to how much of a threat inflation is to the US economy. Powell says the risks to the economic outlook are balanced. And that means continued gradual rate increases.

So what does curve flattening tell us then?

I think curve flattening tells us that the Fed’s policy is tighter than the Fed believes it to be. And this is particularly true because none of the Fed’s rate increases are feeding through to the longer end of the curve. The 10-year Treasury yield is now 2.833%. That’s approximately the same level we had when Powell took over in late January. Meanwhile 2-year rates have gone from 2.145% on January 28th to 2.512% today.

Flattening well into this range below 50 basis points is the point where we should expect credit distress to pick up. Again, right now higher rates are stimulative through the interest income channel. And borrowers concerned about rates rising further will pull forward their plans, adding further stimulus. But at some point, the distress will kick in and overwhelm the positive impact. That will take some time.

And so we should expect the economy to continue to do well. Ignore the noise from the trade and immigration disputes. Instead watch for defaults and restructuring. That is the where the canary in the coalmine will be.


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