Review & Outlook, May 2017

The market places the probability near 100% that the Federal Reserve (Fed) will raise interest rates at the June meeting. The Fed views sluggish first quarter economic growth of 0.7% as transitory. The central bank anticipates the labor market will improve further and inflation will stabilize near its 2% objective. The Fed indicated it will continue gradually normalizing policy rates in 2017 and 2018, provided economic conditions evolve as expected.

Short-Term Treasuries Expect a Fed Pause After June Hike

We anticipate a Fed rate increase in June, barring any unforeseen global developments. But market pricing for short-term U.S. Treasuries appears uncertain beyond the next move. The weaker dollar in 2017 may be foreshadowing a near-term pause in policy rate hikes and less robust growth than the Fed's projections indicate.

The two-year U.S. Treasury note yielded approximately 1.32% following the April jobs data release. Assuming the Fed raises rates in June to a range of 1.0% to 1.25%, the upper limit of the policy target range would nearly equal the two-year Treasury yield. This flattening at the short end of the yield curve is similar to the conclusions of past tightening cycles, rather than the earlier stages.

After the fourth Fed rate hike in 2004, the last tightening cycle, two-year Treasury yields were slightly more than one percentage point higher than the policy rate. The spread was similar or larger following the fourth rate hike in the two tightening cycles before that. The slope between the policy rate and two-year Treasury yield tended to be relatively flat or inverted only when tightening cycles were nearing the end point.

Theoretically, the two-year Treasury yield should equal the expected average policy rate over the coming two years plus a term premium. Current pricing suggests the Fed will pause on rate increases after the anticipated June move.

Two-Year Treasury Yields Slightly Higher Than Fed Funds

Data source: Federal Reserve, Bloomberg, L.P.

Recent data and developments suggest that economic growth may not be evolving quite as the Fed expects. This is likely contributing to the subdued level of short-term Treasury yields relative to policy rates. In addition, the upward pressure on inflation since early 2016 that coincided with a low in oil prices at that time appears to have crested.

Both the CPI and core CPI (excluding food and energy) are decreasing, industrial commodity and energy prices have tumbled recently, wage growth remains subdued and 10-year inflation break-even rates have declined despite further tightening in labor market conditions. Economic growth in China appears to be decelerating as last year's stimulus efforts wane. If so, global disinflationary pressures will likely resume.

Both Inflation and Core Inflation Are Decreasing

Data source: Bureau of Labor Statistics, 1/1/90 - 3/31/17.

Auto sale weakness subtracted approximately 0.5% from first quarter gross domestic product (GDP) growth. That weakness has continued into April, with the sales pace below the first quarter level. Stricter lending standards in segments of the auto finance market will likely remain a sales headwind in the coming months. With large auto inventories and disappointing sales through the first four months of the year, investors should anticipate slower auto production growth in the coming months. More broadly, U.S. economic data have been, on balance, weaker than expected over the past month based on aggregated economic surprise indices. If this trend continues, the Fed will likely need to re-evaluate its conclusion that weakness in the first quarter was largely transitory.

Non-auto consumption data showed some improvement in April. Lessening inflation pressures should continue to support improved consumption from the first quarter. Residential and non-residential investment spending soared during the first quarter, in part due to unusually favorable weather conditions. Some decline is likely in the second quarter. Business equipment spending also posted a well-above-trend increase during the first quarter, so some reversion seems likely. Government spending will likely rebound and less inventory destocking should add to second quarter growth. Overall, available data suggest approximately 2% growth in the second quarter.

The April employment report showed a strong rebound in jobs following a subdued March report. Payrolls gained an average 145,000 jobs over the past two months, slightly less than the average monthly gains of 187,000 in 2016 and 226,000 in 2015. The unemployment rate slipped to a new cyclical low of 4.4% in April, matching the cycle low reached in 2007. Unemployment will likely remain under downward pressure until average job gains slow to around 100,000 per month.

Overall, economic growth should continue expanding at a moderate pace in the quarters ahead. But we believe GDP growth will converge to its longer-term potential growth rate of around 1.5% in 2017. A major fiscal initiative could lift this trend, but we are nearly half way through the year and policy proposals remain only conceptual. Some late cycle indicators are emerging as the unemployment rate reaches prior cyclical lows, the Fed continues to tighten monetary policy and the yield curve flattens.