Review & Outlook, September 2017

Long-term U.S. Treasury yields reached a new 2017 low in early September, hovering near 2%. The decline has mainly been due to modestly diminishing expectations for Federal Reserve (Fed) tightening over the past month and lower foreign bond yields. Reduced odds of Fed tightening and lower foreign bond yields reflect increased uncertainty facing the U.S. and global economies in the coming months.

U.S. economic growth was revised up to 3.0% for the second quarter and data indicate this pace continued through July. Limited August data suggest some deceleration as the third quarter progresses. Auto sales slowed sharply to a 16.0 million unit annual rate. The August employment report was softer across several dimensions, including jobs added, hours worked and wage levels. Employment data were collected prior to the onset of Hurricane Harvey and suggest some organic slowing. Late August auto sales were likely affected by the hurricane in south Texas. The most recent Federal Reserve Beige Book suggests that, overall, the economy continues to grow at a modest to moderate pace.

Economic data is likely to become very noisy in the coming weeks and months due to Hurricanes Harvey and Irma. Initial jobless claims surged by 62,000 for the week ending September 2, with further increases likely in the coming weeks. Looking back, Hurricane Katrina made landfall on August 29, 2005 and significantly affected economic data in the immediate aftermath, as shown below. 

Hurricane Katrina Affected Economic Data

Sources: Jobless Claims, Nonfarm Payrolls: U.S. Department of Labor; Consumer Confidence: The Conference Board; Industrial Production: Federal Reserve Board.

While the effects of any storm are unique, Houston is a much larger metro area than New Orleans. It is the nation's fifth largest metropolitan statistical area, which suggests a potentially larger effect on certain economic data points in the near term.

The initial disruption in activity will likely be followed by some longer-term stimulative effects from rebuilding efforts. The data will not likely reflect these effects until late this year or early next year. Rebuilding efforts were not evident for several months following Hurricane Katrina. The initial disruption, subsequent recovery and rebuilding efforts from Hurricanes Harvey and Irma are unlikely to alter the intermediate-term path of the economic cycle, aside from potential effects on the economic policy calendar and perhaps certain policy initiatives.

An agreement has been reached to lift the debt ceiling, maintain current government funding through mid-December and provide disaster aid in the wake of the hurricanes. This will delay until late in the year potential disruptions from forging longer-term agreements over the debt ceiling, the fiscal 2018 budget, infrastructure spending, tax reform and other key policy items.

Hurricane Katrina did not disrupt the Fed tightening cycle in 2005, despite the resulting short-term weakness in certain data. We do not expect disruptions to the current Fed cycle, particularly as fiscal policy risks have been delayed for the next few months. We should begin to see a small run off in the Fed's long-term security holdings following the September meeting.

Market expectations for a rate hike through the balance of the year have remained below 50% for some time and imply only a modest increase in the policy rate over the next two years. The yield curve is extremely flat on the short end, with 2-year Treasury yields at 1.3%. This also implies very limited policy rate movement over the next couple of years.

The Short End of the Yield Curve is Extremely Flat

Data source: Bloomberg, L.P., 1/1/04 - 8/31/17.

As mentioned earlier, very near-term the disruptions in activity due to the hurricanes will likely result in weaker labor market readings. But this relative weakness should be temporary and is likely to be followed by some strengthening once repair and rebuilding begins. Thus, the Fed will likely look past near-term weakness for policy purposes, particularly in the context of very easy financial conditions.

The dollar and long-term interest rates sit at their 2017 lows, while equities remain near their highs. This continues to imply that financial conditions will boost future economic growth, which the Fed views as undesirable given the low level of unemployment and anecdotal reports of greater difficulty finding qualified workers.

The strength in the labor market and financial conditions is balanced by the general absence of inflationary pressure despite the growing scarcity of qualified workers and by growing concerns among policy makers that high asset valuations present a risk to financial stability. These factors should limit Fed actions to reduction of long-term security holdings through the balance of the year.

Fed policy has been complimented by major global central bank policies over the past several years. While the Fed began normalization in late 2015, other central banks have continued to aggressively ease policy. This should begin to change in 2018. Markets will eagerly await announcements from the European Central Bank in October on its plans to wind down its bond purchasing program next year. China policy is also likely to pivot back toward stability and economic rebalancing from its current orientation of supporting growth following the National Congress meeting anticipated in mid-October. China's efforts in containing North Korea's military actions could also be a factor in trade policy. We still anticipate increasing volatility across the financial markets later this year.