Economic Commentaries

23

In her Congressional testimony Fed Chair Yellen professed optimism that the economy is rebounding from the weakness induced by harsh winter weather. But let’s face some facts. If there were no rebound the economy would be in a full-fledged recession and monetary policy would be under serious critical review. So it is not whether there is a rebound, it is really an issue of the quality and magnitude of the rebound.

First quarter preliminary GDP was reported at 0.1% with inflation running at a 1.4% rate for a nominal growth rate of 1.5%. (Extracting the surge in health care spending and utility outlays, real GDP would have contracted by 1% annually). Leaving aside the distinct possibility of a downward revision to the first quarter report, if inflation holds steady at 1.4% this spring and real growth rebounds to a 3% rate, nominal GDP growth in the first half would be 2.9% or more than 1% below the rise for 2013 and significantly below the Fed’s full year forecast for this year.

So far the spring rebound appears underwhelming. For example, vehicle sales slumped in this year’s first two months, but the selling rate rebounded in March-April as the weather normalized. But the four month average is only 15.7 million or about 4% below the rate in last year’s second half. Similar disappointing performance is evident in housing demand. Indeed builders like Lennar and Hovnanian are finally voicing concern over the weakness of demand, and companies like Trulia and Realogy are now expressing similar concerns.

To be sure, April’s labor market report offered some hopeful signs as payroll growth approached 300K. Unfortunately though, this was countered by a surge in part-time workers, a flat workweek, and a relapse in wage growth to below 2%. We still continue to believe strong payroll and earnings growth are prerequisites to a solid foundation for a rebound in spending. But these prerequisites require sustained strength in business investment and inventory building. Neither seem likely in our environment of weak pricing and revenue growth.

Elsewhere the global PMI for manufacturing slipped in April. Japanese equities are slumping in reaction to April’s sales tax increase. Even optimists are voicing concern over China’s property market. And the ECB is struggling to find a policy to counter approaching deflation and a spiraling currency. In the midst of this Fed Chair Yellen signals that the Fed is likely to maintain its asset taper program with a completion occurring this fall. Meanwhile, long term interest rates are falling around the world and yield curves are flattening.

Our view has been cautious about economic growth and inflation causing us to consistently have thought that benchmark treasuries would fluctuate within a 2.5% to 3% band. And were this range to break our thought has been that it would more likely to be to the downside in yield than to the upside. A failed rebound in economic activity could be the catalyst.

In our view a break through the 2.45% to 2.5% zone cold open the door to a drop to about 2.10%. Short term rates could be expected to relapse as well. Such a development would lower mortgage rates and improve home affordability, perhaps setting the stage for an eventual more genuine rebound in economic activity. This flies in the face of conventional wisdom which is still focused on the timing of eventual interest rate increases by the Federal Reserve. We think this focus is wrong given subdued growth and inflation. Instead we think the focus should be and will eventually turn to the issue of what more the Fed could or may do to support domestic and global activity given continued fiscal paralysis. The negative is that market participants come to believe Central banks are out of bullets. The positive is that this shift in focus might stabilize rates at a lower level which we think would be supportive of growth late this year and in 2015.

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