By Francis P. Rybinski, CFA, Chief Macro Strategist & D. Harris Kere, CFA, Investment Strategist
Led by weaker consumption growth, economic growth slowed in the first quarter, similar to the seasonal weakness exhibited in recent years. Economic activity picked up in the second quarter, with consensus real GDP estimates now above 3%, quarter over quarter. The labor market has continued to strengthen with payroll gains for 2018 surpassing gains over the first half of 2017, confidence remaining elevated, and second quarter data suggesting a rebound in consumption. Additionally, business confidence and activity surveys remain higher than 2017 averages.
Amid a positive string of earnings reports and signs of an economic rebound in the second quarter, investors generally contended less with market volatility and concerns over a more aggressive Federal Reserve, as policy and politics took center stage. President Trump's pursuit of tariffs has only hardened, with the first batch of Chinese tariffs set to take effect in early July. Protectionist and retaliatory trade rhetoric has intensified globally, the continuation of which threatens to increase uncertainty and potentially undermine solid economic progress domestically. Risks around trade policy weren't lost on the Fed as they more forcefully expressed concern over trade wars in the June meeting minutes, even as they stayed the course on normalizing rates.
As expected, the Fed raised the target range for the federal funds rate by 25 basis points at both its March and June meetings to 1.75-2%. Along with raising interest rates, the Federal Open Market Committee also communicated a better outlook for GDP and unemployment, along with slightly higher inflation expectations for 2018. Additionally, their median projection increased to four hikes for 2018, as economic activity solidified and core personal consumption expenditure (PCE) reached 2% during the second quarter, the highest year-over-year increase since 2012. Though inflation rebounded in the first half of the year, upward price pressures should be muted in the second half of the year absent a trade war. Recent CPI readings confirm this view for now, as trend core prices show a downtick in the rate of inflation in spite of a higher June print (Exhibit 1).
Exhibit 1: Core CPI (Annualized)
Sources: Haver Analytics, Aegon AM Macro Strategy. As of June 2018.
The front end of the yield curve continued to reprice as the Fed remained confident in its outlook for steady economic growth and signaled further rate hikes amid increasing Treasury supply. The 10-year Treasury yield settled roughly 13 basis points higher and the 2-year yield about 28 basis points higher in the second quarter, and the spread between the 2- and 10-year Treasuries ended the quarter at its narrowest in more than a decade.
Additionally, the widening of the LIBOR-OIS spread, in this instance more indicative of changes in the economics of money markets than increased financial stress, peaked early in the second quarter. The spread narrowed materially over the quarter, removing a source of potential headline risk from the minds of market participants.
When the Fed's unwind program hits terminal velocity later this year, the balance sheet will be shrinking by $50 billion per month, comprised of $30 billion in Treasuries and $20 billion in mortgage-backed securities. This pace will remove an annual amount of $600 billion in liquidity in 2019 and again in 2020 (Exhibits 2 & 3). The annual pace is roughly equivalent to the entire federal budget deficit of fiscal 2016. That is quite a burdensome amount that must be funded by the private markets and thus takes from investment elsewhere, which would arguably have higher rates of return. (Read more in The Fed Unwind.)
Exhibit 2: Fed Treasury and MBS rolloff schedule
Source: Federal Reserve Board. As of June 2018.
Exhibit 3: Fed balance sheet as % of GDP, 2007 - 2020e
An unprecedented projected decline in Fed balance sheet
Source: Federal Reserve Board, Aegon AM Macro Strategy, Bloomberg. Projection uses rolloff caps, Aegon AM US real GDP forecasts, and 2% inflation. As of June 2018.
It is our view that the Fed would rather contend with a slower pace of rate hikes than a slowdown in the velocity of a balance sheet unwind. The signalling effect from the latter would likely be more prohibitive. A slower unwind would suggest an economy that is not on sound enough footing to warrant a full policy normalization. Conversely, the rates narrative is more fluid, especially as the upper bound of the current fed funds rate, now at 2.0%, is almost inside of the committees estimated range for the long-term rate funds rate, which is 2.25% to 3.50%.
We anticipate GDP growth of around 2.75% for 2018, as the economy benefits from a still healthy global activity and growth-supportive tax policy within the US. Previously, the distribution of risks to our view on US GDP was tilted to the upside. It is more balanced now, particularly for business investment, as trade rhetoric has become more prominent. Following some residual weakness in the first quarter, on par with recent years, growth is likely to strengthen during the subsequent quarters as the benefits from tax policy reach the real economy, and private domestic demand should continue to grow on par with headline real GDP.
Consequently, the labor market should remain strong as cyclical strength pulls in more workers, partially and temporarily offsetting the structural pull lower in participation. We expect the unemployment rate to stay below 4% in 2018, and wages and business investment to firm while consumption, currently above trend, remains steady. Inventories and public spending are likely to be accretive to growth while trade is a growing risk as escalation of current rhetoric and tariffs could negate the positive effects from tax policy and constrict global growth.
While we expect inflation near the Fed's 2% target in the medium term, runaway inflation pressures should remain structurally muted. We are anticipating the FOMC will hike one more time in 2018. While a fourth hike remains possible, we would view the additional move as a policy mistake, especially as the Fed continues to normalize their balance sheet.
Aegon AM US Economic Forecasts
As of 7/02/18
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