Review & Outlook, January 2018

U.S. economic momentum remains strong in the goods-producing sector and has softened slightly in the service sector. Labor market indicators look to be returning to trends evident before the volatility associated with the hurricanes last fall. Financial conditions remain very accommodative, pushing the market-based odds of another Federal Reserve (Fed) rate hike in March to more than 80%.

Goods-Producing Sector Supports Growth

Fourth quarter U.S. gross domestic product (GDP) appears to have grown by about 2.5%. Consumer spending has been solid, rising at a 2.7% annual rate. Housing and business equipment investment remain strong, both looking to increase nearly 10%. Government spending should contribute modestly to growth during the quarter. However, commercial construction spending is essentially flat. A widening trade deficit, along with slower inventory investment, will likely subtract from growth overall.

Both the December employment data and purchasing manager indices showed activity skewed to the goods-producing sector. The overall employment gain of 148,000 jobs was modestly below longer-term trends and the unemployment rate held steady. Gains in manufacturing and construction jobs remained robust. In contrast, retail sector employment was weak and overall service sector employment fell below recent trends.

Similarly, the ISM manufacturing index bounced to a robust 59.7 in December, while the ISM non-manufacturing index pulled back relatively sharply. The relative strength in the goods-producing sector likely reflects: 1) strength in recent foreign economic activity readings that is benefiting the tradable goods sector and 2) ongoing recovery and rebuilding efforts following the hurricanes last year that have boosted construction and other spending.

Manufacturing Was Robust in December

Data source: Institute for Supply Management, 1 Dec 2010 - 31 Dec 2017.

Both the service and manufacturing sector surveys indicated rising prices, particularly in the manufacturing sector and remain consistent with the mild upward trend reported in the producer price index. Longer-term inflation compensation also increased over the past month, with 10-year U.S. Treasury breakeven rates moving above 2% for the first time since the election after the turn of the year. We should expect near-term inflation pressures to remain upward, based on the increase in oil prices, the fully employed labor market and various indicators.

The likely mild upward pressure on inflation measures should not materially change the Fed's outlook. Expectations for an increase toward 2% inflation have been firmly in place among a majority of policymakers. Market pricing implies better than an 80% chance of an additional rate increase at the March Fed meeting. While market-based expectations for additional rate hikes beyond March remain muted, it will likely require tightening in broad financial conditions to push the Fed to the sidelines.

U.S. Treasury yields have increased modestly in response. The 10-year yield approached 2.6% in early January, near the post-election high. Upward pressure should continue from a March Fed rate hike and a likely increase in foreign long-term bond yields from improving conditions in the major foreign economies. Continued equity gains and ongoing dollar weakness have balanced the effect of rising yields on broader financial conditions.

Two more increases in the fed funds rate will put the policy rate at the upper bound of 2%, likely by the summer. At that point, the rate will be approximately 1.5% above its 10-year average.

The tightening cycles in both 2000 and 2006 ended when the policy rate exceeded its 10-year average by this magnitude. We expect a similar pattern in the months ahead and would view a peak in the fed funds rate as a good point to consider adding exposure to longer-term bonds.

Fed Funds Rate Approaches an Important Milestone

Data source: Federal Reserve, 1 Jan 1983 - 31 Dec 2017.