March Quick Read on the US Economy

In my opinion, the latest numbers on the US economy were positive last month. After plummeting for the first half of February, stock markets became markedly more positive over the second half. International equity prices seem to have regained their footing and oil prices are well off the lows of the year as well. I still see the global growth environment as tepid: with the US being the main bright spot. Despite the international headwinds, I expect the Fed to begin to signal it will continue to tighten according to plan.

Domestic highlights in February

Our Astor Economic Index® (“AEI”) shows growth somewhat above the recent average and slightly stronger than last month. The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

I saw the employment report (nonfarm payrolls) for February as broadly positive. The number of new jobs was almost exactly at its two year average. I see no sign of broad based weakness in the economy when viewing the payroll numbers. Readers who want to burnish the negative case may have to dive into the weekly aggregate payroll. This number takes the number of employees and multiplies by the hours per week and again by dollars per hour. The result is something like a weekly wage bill and it posted a rare down month in February as hourly earnings and hours worked both posted modest declines.

In short: I think the pessimism in the first two months of the year were driven by fearful projections rather than data and that current views of the state of US economy are more realistic.

International environment

Last month, I was hoping for signs of strength in the world manufacturing cycle. It seems as if my hopes will have to wait at least until spring. While the Institute for Supply Management’s Manufacturing Index for the US showed a modest (but welcome!) bounce for the month, the picture in the rest of the world was not so rosy. The chart below weighs PMIs in roughly the G-20 countries, each one weighed by their GDP. This measure is looking for new low since 2012.

 

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Source: Institute for Supply Management, Markit, Astor calculations

The Fed

I believe the next red-letter day for the market should be FOMC Chair Yellen’s post meeting press conference on March 16th. Few expect the Fed to raise rates but many will be placing bets on the nature of the committee’s communications. Will the FOMC be hawkish or dovish? The Fed has repeatedly said they are data dependent and not tied to the calendar. However, as University of Oregon Economist Tim Duy has pointed out: we will need some clarity on which data they are dependent on.

In my view, the case for promising to raise rates again soon is that continued strength in the economy will move unemployment below the natural rate by a fair amount and perhaps for an extended period. In the view of Vice Chair Stanley Fischer for example, such labor market strength would risk setting off enough of an inflationary process that even larger rate hikes would be necessary to contain it.

However, I believe there are several complicating factors to give the Hawks a pause. First, is the tightening of financial conditions reflected in higher rates for corporate borrowers as well as the volatility and general decline of equity prices.  Second, inflation expectations, while hard to measure, may be declining. Inflation expectations derived from market prices are substantially lower than they were a year ago though survey-based expectations may have stabilized.  The chart below shows five year forward forecasts of CPI from surveys an derived from market prices.

infl.png

Source: Bloomberg, Federal Reserve bank of Philadelphia

My prediction is the Fed will raise not rates in either March or April and instead, focus on the tightening in the financial markets and weakness in inflation expectations in its released statement.  Therefore I am expecting the Fed to promise two or more hikes in 2016.   My preference (if I were a voter) would be for the Fed to make it clear that it is willing to be symmetrical around the 2% inflation target and would tolerate a year or two above the target as we have spent each of the last 8 years below it.

Conclusion

Overall, I am pleased to see continued growth in the US despite the tepid international environment. I expect the Fed to try to move back towards, but not fully achieve, its plan of four hikes this year.


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The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

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The Fed’s Inflation Problem

As 2014 draws to a close the Fed is presented with a problem. Based on recent speeches, a substantial part of the committee seems eager to raise rates. At the same time. some of the Fed’s preferred metrics suggest this may be premature and the market is trapped in between. Market participants are on the lookout for clarity in next week’s press conference from Chair Janet Yellen. The expectation among Fed watchers is that at next week Yellen will solidify expectations that rates will begin to rise in June 2015.

Why do I think the Fed is getting ready to raise rates? We discussed the shifting composition of the voters on the committee a few weeks ago and came to the conclusion that the shift involved roughly equal numbers of hawks and doves coming and going. When we look at the statements from the permanent members such as Vice Chair Stanley Fischer (see this WSJ interview) and NY Fed President Dudley, I see a more hawkish tone.

Why this shift? Below I graph the Fed’s performance against its dual mandates of stable prices and full employment.   The chart shows unemployment and inflation along with the Fed’s inflation target (in blue) and the unemployment rate consistent with stable prices (in pink). The economy has improved without inflation over the last five years.   Today, the Fed is in the happy spot where there is slack in both inflation and unemployment.

phillips.pce-2014-12-09

With inflation below target today, are inflation expectations what are causing the hawkish tilt?  Not really. The chart below shows three measures of inflation expectations – two derived from various market prices and one from a survey of professional economists asking for the average inflation rate expected over the next five years. Any way we look at it, inflation expectations for the intermediate term are low and, if anything, falling. It is not clear to me what, other than a simple distaste for rates remaining at the zero lower bound is moving the Fed to raise rates

infl

What does the market think about the Fed’s likelihood of raising rates? We can plot the fed funds futures against the Fed’s forecast of where rates will be at year end as revealed in their quarterly reports. This chart shows that as of yearend 2015 the FOMC expects short term rates to be around 1.375% (up from about 0.125%) and the fed fund futures market expects the same rate to average around 0.55% that month.

Forecasts of the fed funds rate

We see similar skepticism in the low level of yields in US treasures. One interpretation of US ten year bonds yielding 2.16% is that the Fed’s expectations of rates (the blue dots) are either will not materialize or will need to be quickly reversed. That is, if the bond market believe that short term rates were going to 3.75% by 2017 and staying there, the ten year bond would yield a lot closer to 3.75%. In fact the Fed’s survey of major market participants reveals a 20-30% possibility that the Fed will be led to quickly undo its rate rise. It would not be the only central bank to reverse course since the crisis.

How might the Fed square the circle? If inflation expectations remain low it is hard to see the forecast of rates represented by the blue dots coming to pass. On the surface, this is very odd. The fed gets to set the level of short term interest rates, its forecasts of fed funds should be as accurate as my forecasts of my daughter’s allowance: completely with the control of the forecaster.   Perhaps the forecast should be seen a way as allowing hawkish members to blow off steam. If so, it would be better to discontinue them.

I am currently expecting 1) the Fed will raise short term interest rates beginning in June 2) they will only raise rates slightly over the course of the year and fed funds will end the year below 1%. It will remain to be seen if the Fed will walk back the higher expectations found in their quarterly forecasts. My guess is that hints of more aggressive moves will cause some substantial moves in the fixed income markets.

(Other views of the upcoming meeting you should consider: Tim Duy, Gavyn Davies, Paul Krugman)