Slower Growth in 2014
In a disappointing start to the year, the Bureau of Economic Analysis reported that the U.S. economy contracted 2.9 percent in Q1 (top graph). While many analysts were expecting a sharper negative number, the reading was much weaker than many forecasters expected. On the heels of the GDP report, the personal income and spending report signaled that inflation was picking up while real consumer spending declined in the first two months of the second quarter. After accounting for the downward revision to GDP and our reduced outlook for consumer spending in the second quarter, we now suspect that 2014 GDP growth will downshift to just 1.4 percent this year after last year’s 1.9 percent. So how have interest rates responded?The reality is that forward looking interest rates were not dramatically affected. After a brief pullback, the yield on the 10-year Treasury resumed edging higher. Why?
Tracking Growth but Inflation and Global Forces Matter Too
Markets do not live by GDP alone. Treasury yields managed to track the slowdown in economic activity quite well in the first quarter (middle graph). The yield on the 10-year Treasury peaked around the second week of January before coming back down. However, as of the beginning of June, rates have started to edge slightly higher in a signal that reflects the strengthening economic growth environment we expect in the second quarter. Meanwhile, year-over-year inflation has begun to creep upward. Looking forward, we maintain our view that the second half of this year will be characterized by GDP growth in the 2.5 to 3.0 percent range. The stronger growth environment, along with inflation picking up, has put a floor on the drop in market rates despite the large negative GDP print. Finally, talk in the U.K. of interest rate increases has put greater balance in global capital markets as the bet on continued lower rates must be tempered.Yield Curve Continues to Tighten This Year despite GDP
Traditionally, the yield curve serves as a leading indicator of economic activity. Unfortunately, with the emergence of the Fed’s quantitative easing and “operation twist” efforts, there is a question about its reliability. For our efforts, the yield curve still retains some significance and the recent tightening of the 10- to 2-year spread indicates some moderation in the optimistic end of economic forecasts and that our below consensus outlook at the beginning of this year has played out very well compared to the Blue Chip consensus. Moreover, our interest rate outlook has kept us on the low side of market expectations. Within the global context, U.S. interest rates face a broader set of influences than just GDP.
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