Updated: 06-26-2017

U.S. Data Fails to Rebound from Weak First Quarter
Updated: 16-Jun-17  04:01PM ET
Analyst: David Kelland

The U.S. economic data out this week was disappointing on the output, price, and sentiment fronts:

  • On output, retail sales and housing starts both missed forecasts while industrial production managed to come out as expected
  • On prices, the core PPI beat estimates for May (0.3% m/m vs. Briefing.com consensus 0.3%) but the CPI and core CPI both missed by a tenth (-0.1% and 0.1%, respectively)
  • On sentiment, the Michigan Sentiment Index fell to a post-U.S. election low (94.5 vs. Briefing.com consensus 97.0) and the NAHB Housing Market Index of homebuilder sentiment fell to 67 from 69 (Briefing.com consensus 70). The Empire Manufacturing Index, however, jumped to a two-year high (19.8 vs. Briefing.com consensus 6.0)
Collectively, the data are not terrible but the Atlanta, New York and St. Louis Fed's models reduced their estimates to forecast Q2 real GDP growth of 2.9%, 1.9%, and 2.3%, respectively. Slower growth does, however, make the economy more vulnerable to a shock. The residual seasonality in the GDP model was also supposed to produce a Q2 boost following the Q1 weakness.

Long-term Treasury yields have been reflecting declining growth and inflation expectations since March at the same time as short-term yields have moved higher with the Fed's rate hikes. There are a few possible catalysts for the flattening.

  • The first is that inflation figures have been undershooting in the U.S. for a few months and that may be building confidence among holders of long-term Treasuries that inflation will not get back to 2% before another downturn sends it lower again. Year-on-year oil price growth has quickly faded to zero as the year has wound on and the February 2016 low in oil prices has slipped into statistical history.
  • Second, the Fed has now signaled that it will not abruptly halt the reinvestments of its asset portfolio but will instead phase in the unwinding. Quiescent inflation in the eurozone should also allow the European Central Bank to continue its asset purchase program well into 2018. Asset purchase programs at the Fed, the ECB, and the Bank of Japan have the effect of flattening yield curves and reducing term premia.
  • The third reason for the flattening of the yield curve is that the Republican control of legislative policymaking has not led to the debt binges that it did during the Reagan and Bush 43 Administrations. Sharply higher federal borrowing for supply-side tax cuts and infrastructure spending could have pushed the Fed's neutral rate of interest (r*) higher this year and even kept it higher for many years to come. The Trump Administration has turned out to be less than adept at reaching across the aisle to solve its razor-thin-Senate-majority problem. Also, President Trump's low approval ratings are not producing a coattail effect that might have otherwise helped push some decidedly unpopulist legislation through Congress. Senate Republicans are trying again on healthcare reform but that would still not be the budget buster that bond markets had feared during the winter.

I lean toward the third explanation as the most important, especially considering the sharp jump in yields when the Republicans swept to power in November

There was also an FOMC meeting this week. The Committee said in its statement that it would monitor inflation developments closely and that was the only bone thrown to traders betting that the Fed will not hike again in 2017. The core inflation forecast for FY2017 was reduced to 1.7% from 1.9% previously. Dallas Fed President Kaplan said today that voting to raise rates was a tough decision for him. Minneapolis Fed President Neel Kashkari dissented in Wednesday's decision and, presumably, Chicago Fed President Evans and Fed Governor Brainard had a bit of trouble voting to hike too. Charles Evans will speak on Monday evening.

As for the Fed's balance sheet, it now looks like the reduction will begin sometime in the fourth quarter. The first quarter will see a $10 bln/month cap to the balance sheet reduction, $20 bln/month in the second quarter of implementation, and so on until the cap is at $50 bln/month. Minneapolis Fed President Kashkari said today that he would have liked to see the Committee specify a start date at the meeting to reduce uncertainty. Either way, the Treasury market looks awfully unconcerned with the 30-year Treasury yield within two basis points of a seven-month low.

- David Kelland, Briefing.com

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