Macro and Rates Update

By Francis P. Rybinski, CFA, Chief Macro Strategist and D. Harris Kere, CFA, Investment Strategist

Macro outlook

Gross domestic product

Advance gross domestic product (GDP) data show that economic growth in the first quarter was an annualized 2.3%, exhibiting once more the first quarter weakness observed in recent years, albeit coming in above expectations. Contraction in motor vehicle purchases, following a hurricane season-induced unusually strong fourth quarter, dampened consumption. A weaker pace of equipment spending growth, after an unsustainably strong fourth quarter, offset solid growth in structures and softened business investment in the first quarter. Trade was no longer a drag on GDP growth, while government spending contributed less, relative to the fourth quarter. Economic growth accelerated to 2.9% year over year in the first quarter, and the core economy is still healthy as private domestic demand growth remains above headline GDP at 3% year over year. Economic growth in the fourth quarter was an annualized 2.9%, up from the prior estimate of 2.5%. The economy grew 2.6% year over year, and 2.3% for 2017. (For a comprehensive look at our forecasts, please see Exhibits 1 and 2.)

Exhibit 1: 2018 GDP forecasts

Source: Bloomberg, Aegon AM US Macro Strategy, as of April 2018

Exhibit 2: Aegon AM US economic forecasts
All values in %

Source: Aegon AM US Macro Strategy. As of 4/13/18

Labor market and the consumer

For the first quarter of 2018, the headline unemployment rate remained steady at 4.1%, belying a healthier labor market as more civilians were pulled into the workforce during the first quarter, and suggesting a broad underestimation of the labor market slack that has persisted in the current expansion. Indeed, the labor force participation rate has improved from the fourth quarter: the U6 measure of underemployment, which includes those who work part time but want a full-time job, has inched further down; nonfarm payrolls have averaged close to 202,000 over the quarter; and the employment-to-population ratio ended the quarter at an expansion high of 60.3%.

Despite a softer GDP print in the first quarter, the US is still in the midst of domestic and global cyclical upticks in activity and output. Positive consumer sentiment in the US has remained rather resilient since an initial post-election surge, as evidenced by the recent Conference Board and University of Michigan consumer surveys. As the labor market continues to strengthen, consumer sentiment, wages, and spending should gain broad support, and consumption should provide a boost to the economy for the remainder of the year. Indeed, average hourly earnings accelerated to an annualized 3.05% quarter over quarter, and 2.66% year over year. In addition the employment cost index shows that wages and salaries for civilian workers grew at a faster pace over the quarter (3.75%) and the year ending March 31 (2.7 %).


Over the quarter, the labor market's strength has prompted increased sensitivity to wage growth and more pronounced concerns over of a material pick-up in inflation and potential policy mistakes from a more hawkish Federal Reserve. Core PCE inflation trended up to 1.70% year-on-year over the first quarter, and headline CPI has accelerated to 2.25% year-on-year over the first quarter. We have recently opined on both the inflation experience and trajectory. We believe inflation will slowly pick up in both the short and medium terms, as the downward pull from transitory factors—such as the drop in wireless services and quality adjustment last year—recede, labor slack is further absorbed, and inflation expectations around the Fed's objective remain anchored.

Structural factors, however, suggest that the Fed's 2% inflation objective is more of a ceiling than a symmetrical target.

Private investment

Though equipment spending growth has slowed in the first quarter from unsustainable fourth quarter levels, it is our view that private investment in the US is in a cyclical uptick, one that began prior to tax policy implementation and should continue this year. Private non-residential investment growth has only marginally cooled to 6% year over year, a pace last seen in late 2014 prior to the fourth quarter of 2017, bolstered by equipment spending. A late cycle fiscal nudge that favors the expensing of equipment investments could support that trend, and, for now, surveys suggest healthy private investment, as can be seen in Exhibit 3.

Exhibit 3: Confidence is rising

Sources: NFIB, Duke Fuqua CFO Outlook, Business Roundtable, retrieved from Haver Analytics as of Q1 2018

In addition, the use of capital relative to labor has fallen off trend in recent years, as can be seen in Exhibit 4.

Exhibit 4: Capital intensity relative to labor is off trend

Sources: Bureau of Labor Statistics, Aegon AM US Macro Srategy, Haver Analytics, as of 2017.

As wage pressures build and labor costs mount, capital becomes relatively cheaper, which should prompt the substitution of capital for labor in production (Exhibit 5). This has potential implications for labor productivity, which has suffered from a relative dearth of capital during the current expansion.

Exhibit 5: Capital getting cheaper relative to labor

Source: Bureau of Labor Statistics, Aegon AM US Macro Strategy, as of 2017.

Source: Bureau of Labor Statistics, Aegon AM US Macro Strategy, as of 2017.

There is a potential downside risk, especially in industry activity, should bouts of trade rhetoric and the resulting economic uncertainty dampen optimism and discourage investment.

Rates outlook

1. Given ongoing economic improvement in the US economy, the FOMC remains in accommodation-removal mode.

  • Relative weakness in global economic and inflation data, along with an increase in future fed funds expectations, has strengthened the US dollar. Ongoing US dollar strength could curtail the ability for the FOMC to hike in 2018.
  • The disparity between market expectation of future hikes and the FOMC's "Dot Plot" of the Committee's expectations for the level of fed funds in the future has significantly compressed, with the FOMC estimating two additional hikes in 2018 and the market now pricing in 2.6 additional hikes. We view it unlikely the FOMC hikes 3 more times in 2018, with 1-2 as the most likely outcome.
  • The future pace of FOMC hikes will remain largely a function of US inflation and the labor market, with the bar for the FOMC to hike 3 more times being very high.
  • Threats of tariffs by the Trump Administration has stoked fears of an escalating trade war, rattling equity markets and tightening financial conditions. If this escalates further, it poses additional headwinds to the FOMC aggressively hiking the federal funds rate.
  • The FOMC's tapering of its balance sheet has, to date, had little direct influence on capital markets. However, the pace of the FOMC's balance sheet runoff is likely to increase modestly over the next 12 months. Overall, we estimate it will take 3 – 3.5 years before the FOMC's balance sheet reaches its target (the FOMC hasn't articulated what this is yet, but we estimate it will be around $2.25 trillion). It could be a bit longer if rates rise significantly or the FOMC's actual target is lower.
  • Given this relatively slow unwind of the balance sheet, the direct impact to Treasury yields from tapering should remain modest, although it is expected to grow over time. We currently estimate it to be somewhere in the neighborhood of 5-10 bps per year, cumulatively.
  • Over the first quarter, the late cycle fiscal push, notably via tax policy and the bipartisan budget act, has also led to concerns that federal funding needs would pressure long yields upwards. We estimate that each percentage point increase in the deficit relative to GDP could raise the 10-year US Treasury yield by roughly 10 basis points, all else being equal. The Congressional Budget Office (CBO) projects the fiscal deficit to be 5.1% of GDP by 2028, from a 2017 baseline of 3.5% (to be sure, nominal GDP is projected to grow alongside the deficit), the isolated effects of funding needs on the 10-year part of the US Treasury curve should be modest, especially as they relate to the influence of inflation concerns and global sovereign rates.

2. Inflation will remain a significant driver of rates over the next 6-12 months, although US Treasuries will remain somewhat anchored to global sovereign rates.

  • Given inflation's recent, modest recovery, the market will likely remain sensitive to price level changes over the coming months.
  • Although inflation, as measured by core PCE, is now very close to the FOMC's 2% inflation target, the recent upward bump is largely a mathematical function of last year's weak March print. Aegon Asset Management's economic team believes inflation is unlikely to surge much higher over the coming year, which should keep longer rates from running away to the upside.
  • To date, the Phillips curve has been relatively flat. With unemployment likely to break below 4%, the market will remain vigilant for signs of an uptick in employment costs.
  • Treasury yields remain linked to foreign sovereign yields. Now that the LIBOR-OIS (overnight indexed swaps) spread appears to have peaked, it could reduce the cost of foreign buyers hedging USD risk, potentially increasing the attractiveness of Treasuries relative to other sovereign debt.

3. Even before the tax cut, we expected the US economy to continue expanding, pressuring rates modestly higher in the coming months/quarters, but not necessarily in a straight line.

  • Prior to tax cuts being passed into law, the US economy was already growing at a relatively steady pace. The tax cuts should provide an additional boost to the economy, although the magnitude of this boost, the timing of when it will occur, and the areas of the economy that will be most affected still remain a question mark.
  • Despite these outstanding questions, the markets have become relatively optimistic about the near-term ability of the FOMC to raise rates.
  • Given this near-term optimism, there is some risk that the market becomes disappointed or disillusioned, and interest rates could remain volatile prior to moving higher into year-end 2018.
  • Barring significant additional trade-war escalations, we believe it will be very difficult for 10-year US Treasury rates to break materially below 2.50%.


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