The U.S. economy has momentum and is headed for its longest expansion on record. But while the Fed can continue to hike, it needs to do so gradually. Inflation, financial conditions (including the US$), and international developments matter.
Real and nominal U.S. GDP readings were revised up to 4.2% q/q AR and 7.6%, respectively in 2Q. U.S. corporate profits before tax increased 7.7% y/y in 2Q. We’ve never had a U.S. recession with corporate profits doing well. Trade concerns seem to be impacting countries abroad more than the U.S. thus far.
We’ve had a move up in inflation (U.S. + abroad), but this is getting to be old news. Inflation still looks manageable. The main worry seems to stem from the U.S. seeing fiscal stimulus & deregulation at full employment (worth noting, the “overheating” argument and the “peak earnings / cliff” argument can’t BOTH be correct at the same time).
Also, inflation does not appear to be impacting consumer confidence much, with the Conf Board reading hitting a new cycle high at 133.4 in Aug. The U of Mich confidence survey ticked slightly lower, but not much, in Aug. If inflation is not impacting consumer confidence (think higher gasoline prices as an example), we’re likely in “manageable” territory.
With this backdrop, we are still watching the flattening U.S. yield curve closely. Of all the “wall of worry” items (trade, peak earnings, inflation, midterm elections, Fed hikes, aggregate debt levels) the yield curve remains one of the biggest. Recent SF Fed research has noted that: “the term premium does not appear to have any incremental predictive power relative to current term spreads. In other words, a negative term spread signals high recession risk, regardless of whether a low term premium or low short-rate expectations are holding down long-term interest rates… There is [also] no clear evidence in the data that ‘this time is different’ or that forecasters should ignore part of the current yield curve flattening because of the presumed macro-financial effects of QE.” (Bauer & Mertens, 2018)
We are treating the U.S. yield curve as binary: flat is ok, inverted is not ok. We can watch different curves (2yr/10yr spread, 3m/10yr spread, etc) but they tend to move together. An inverted curve cannot be excused because of a negative term premium or QE. Strategas’ Fixed Income Strategist Tom Tzitzouris would make an even stronger statement, ie, a negative term premium is telling us something is wrong: there’s a massive bond market bet that the Fed will not get inflation up anytime soon. This confidence most likely comes from a view that the FOMC will break the economy quickly, if it continues on its (forecasted) tightening path. Additionally, inverting the curve at low interest rates is an extra-high hurdle, requiring substantial bond buying. Quant programs keying off an inverted curve (and its good correlation with economic events historically) are also likely agnostic as to whether any inversion is “fundamental” or “technical.”
Bottom line: a September Fed hike is close to a done deal. After that, a Fed pause is probably the key macro event to watch for in 4Q or 1Q. Our hope remains that the U.S. can duplicate the 1994-98 period (which saw a flat but not inverted yield curve). It’s certainly hard to find a problem in the U.S. economy now (bank standards are easing, corporate spreads are still narrow, stress indicators are contained). But it’s easier to see trouble abroad (China, E.M., Italy, etc). Maybe the U.S. will stay insulated, but the 1998 LTCM event shows there are inter-links as global liquidity tightens. The weakest links go first now (Turkey, Venezuela, Argentina), so a key question is “now what?” We’re staying tuned.
Don Rissmiller, Strategas, September 4, 2018.