Slow and steady (muddle through) economic activity
Real GDP and nominal GDP respectively increased by 2.08% (YOY) and 3.71% (YOY) in Q2 2017. Both of these figures have averaged a little over this since Q1 2010.
Low inflation that has been consistently below target
Even if one ignores the worst parts of the recession, inflation has averaged 1.6% since the beginning of 2010. The recent Q2 2017 reading continues to confirm this trend coming in at 1.6%. Market based inflation expectations have increased since 2016, but remain well anchored as they are presently below 2%. Whichever way one looks at the inflation picture and outlook, the Fed has either persistently treated 2% as a ceiling rather than a target or their monetary policy tools have been ineffective in achieving their mandate. If it is the former, solely based on inflation, it can be argued that monetary policy has been too tight for the length of the recovery.
Labor market slack despite cyclically low unemployment
Although the unemployment rate has been below 4.5%, both the prime (25-54 years old) labor force participation and employment rates are still below levels seen in the prior two expansions. The prime age employment ratio remains 1.7% and 3.3% below the highs of May 2007 and April 2000. The prime age civilian labor force participation rate confirms this given that it is 1.4% and 2.8% below June 2007 and January 1999. Moreover, despite improvements since 2015, hourly wage growth is actually more consistent with prior recessionary lows. Wage growth is roughly half of what was experienced in the last two expansions. All this still points to labor market slack.
A flat Phillips curve (theoretical inverse relationship between unemployment and inflation)
In theory, rebounding total dollar spending (sales) on goods and services (aggregate demand) induces firms to hire workers. In doing so, falling unemployment restores labor's bargaining power which enables them to demand higher wages. Firms react by passing on rising costs onto consumers by increasing goods/service prices. This has failed to materialize. Therefore, either the Phillips curve view of inflation determination has failed once again or the unemployment rate has not been a good indicator of labor market slack seeing as labor costs have been subdued. At the very least a flat Phillips curve suggests that the current rate of unemployment is still likely above the natural rate. This would indicate that the unemployment rate could fall (much?) further before any price pressures arrive. At worst, unemployment may have little or nothing to do with inflation.
A favorable financial environment yielding relative little private investment spending
Judging by compressed credit spreads and US equities indices routinely hitting all-time highs, financial conditions certainly haven't been too restrictive by any means. In other words, corporations should have no issues funding their activities. Yet, gross private domestic investment relative to nominal GDP has disappointed throughout this current expansion. Much like the employment picture, the pace of private investment has lagged behind every expansion since at least the 1980s.
Weak productivity growth
Since 2010, the annual percentage change of nonfarm business sector real output per person has averaged less than 1%.
A Fed intent on tightening
Despite steady but disappointing economic growth, below target inflation, labor market slack, weak private investment, a flat Phillips curve, and depressed productivity growth possibly (at least in part) as a result of depressed aggregate demand, the Fed has preemptively increased policy rates four times to ward off overheating a tepid domestic economy. Moreover, neither long-term treasury rates nor the dollar have reacted as one would have anticipated given Fed tightening. Before each of the rate hikes, market participants have front run the Fed by bidding up long-term treasury rates and the dollar only for this to reverse shortly follow Fed rate announcements. December 2015, December 2016, and March 2017 have mark intermediate tops in the 10 year treasury rate. This has also been the case and has been even more pronounced when it comes to the dollar. Falling long-term treasury rates and dollar FX both may suggest that market participants are skeptical that the Fed will able to continue on this course without driving down inflation and growth.
A quick look at DXY, TNX, EUR, JPY, Gold, Oil, & EM
*Now in the event the dollar were to resume it's prior uptrend while long-term treasury rates fell, this would signal caution. This combination is usually symptomatic of a risk-off environment. See the following two posts to explore the short-term and long-term possible scenarios.
Real GDP and nominal GDP respectively increased by 2.08% (YOY) and 3.71% (YOY) in Q2 2017. Both of these figures have averaged a little over this since Q1 2010.
Low inflation that has been consistently below target
Even if one ignores the worst parts of the recession, inflation has averaged 1.6% since the beginning of 2010. The recent Q2 2017 reading continues to confirm this trend coming in at 1.6%. Market based inflation expectations have increased since 2016, but remain well anchored as they are presently below 2%. Whichever way one looks at the inflation picture and outlook, the Fed has either persistently treated 2% as a ceiling rather than a target or their monetary policy tools have been ineffective in achieving their mandate. If it is the former, solely based on inflation, it can be argued that monetary policy has been too tight for the length of the recovery.
Labor market slack despite cyclically low unemployment
Although the unemployment rate has been below 4.5%, both the prime (25-54 years old) labor force participation and employment rates are still below levels seen in the prior two expansions. The prime age employment ratio remains 1.7% and 3.3% below the highs of May 2007 and April 2000. The prime age civilian labor force participation rate confirms this given that it is 1.4% and 2.8% below June 2007 and January 1999. Moreover, despite improvements since 2015, hourly wage growth is actually more consistent with prior recessionary lows. Wage growth is roughly half of what was experienced in the last two expansions. All this still points to labor market slack.
In theory, rebounding total dollar spending (sales) on goods and services (aggregate demand) induces firms to hire workers. In doing so, falling unemployment restores labor's bargaining power which enables them to demand higher wages. Firms react by passing on rising costs onto consumers by increasing goods/service prices. This has failed to materialize. Therefore, either the Phillips curve view of inflation determination has failed once again or the unemployment rate has not been a good indicator of labor market slack seeing as labor costs have been subdued. At the very least a flat Phillips curve suggests that the current rate of unemployment is still likely above the natural rate. This would indicate that the unemployment rate could fall (much?) further before any price pressures arrive. At worst, unemployment may have little or nothing to do with inflation.
A favorable financial environment yielding relative little private investment spending
Judging by compressed credit spreads and US equities indices routinely hitting all-time highs, financial conditions certainly haven't been too restrictive by any means. In other words, corporations should have no issues funding their activities. Yet, gross private domestic investment relative to nominal GDP has disappointed throughout this current expansion. Much like the employment picture, the pace of private investment has lagged behind every expansion since at least the 1980s.
Weak productivity growth
Since 2010, the annual percentage change of nonfarm business sector real output per person has averaged less than 1%.
- The supply side camp reasons that the productivity slowdown may be due to demographic trends, poorly skilled workers ("skills gap"), too much spending on social insurance, a lack of broad based innovation, corporate over taxation etc. In other words, the US along with other developed economies have experienced a negative supply shock that has caused chronically slow growth and low productivity.
- Another camp reasons that a lack of much stronger broad based corporate revenues/sales (aggregate demand) is depressing output, private investment, and therefore productivity. Monetary and fiscal policy have not done enough to raise the expected path of nominal GDP. Furthermore, globalization and technology have actually produced a positive not a negative supply shock resulting in an excess supply of global labor. As wages in developed economies converge lower to their developing market peers, this slow wage growth environment has incentivized corporations to substitute labor for capital. Without much stronger expected future revenues and tighter labor markets, why would firms risk investing in capital?
A Fed intent on tightening
Despite steady but disappointing economic growth, below target inflation, labor market slack, weak private investment, a flat Phillips curve, and depressed productivity growth possibly (at least in part) as a result of depressed aggregate demand, the Fed has preemptively increased policy rates four times to ward off overheating a tepid domestic economy. Moreover, neither long-term treasury rates nor the dollar have reacted as one would have anticipated given Fed tightening. Before each of the rate hikes, market participants have front run the Fed by bidding up long-term treasury rates and the dollar only for this to reverse shortly follow Fed rate announcements. December 2015, December 2016, and March 2017 have mark intermediate tops in the 10 year treasury rate. This has also been the case and has been even more pronounced when it comes to the dollar. Falling long-term treasury rates and dollar FX both may suggest that market participants are skeptical that the Fed will able to continue on this course without driving down inflation and growth.
A quick look at DXY, TNX, EUR, JPY, Gold, Oil, & EM
- The dollar index (DXY) has found support at $93 which has held in range bound trading since January 2015.
- In this recent dollar sell off following the January 2017 intermediate top, long-term treasury rates have drifted lower.
- As the next charts show, these moves in the dollar and rates have had global repercussions.
- The spread between US and Euro six month forward rates have tracked the trade weighted dollar index.
- This same behavior is seen in longer term rate spreads as well. As USD-EUR spreads compress, the dollar should continue to come under pressure. On the other hand, a steepening in the US relative to the EUR yield curve should cause the dollar to appreciate after hitting an intermediate term bottom.
- The Yen has continued to trade in tango with 10-year treasury rates.
- A break above 2.4% in the 10-year should see the Yen weaken against the dollar.
- However should US rates break below 2.1%, the Yen is likely to appreciate.
- The same can be said for Gold and the precious metals complex which has traded with JPY.
- The long end of the US yield curve bears watching. With inflation more or less anchored below 2%, declining nominal rates may serve as an indication that US long-term real rates could be set to decline.
- This would make for a positive trading environment for precious metals. With that said, a rebound in the long end of the yield curve would serve as a headwind.
- Much like EUR, JPY, Gold, the dollar's next move coupled with the long end of the US yield curve should cause crude oil to breakout of it's messy trendless that has been observed since the beginning of 2016.
- As the chart shows, oil have closely mimicked EUR/USD. If US long-term risk free rates continue to underperform their European counterparts, this should prove beneficial for EUR as well as oil.
- It should come as no surprise that the dollar sell off has facilitated a rebound in the rest of the world.
- Beginning in January 2016, dollar debt issuing global entities (EM) have rallied.
- This has also conveniently reduced pressure on China after market participants feared the worst at the start of 2016.
Conclusion
Should the dollar index (DXY) definitively break below $93 support and the US yield curve continue to flatten as long-term nominal treasury rates decline, this should bode well for EUR, Yen, Gold, Oil, and EM. Clearly the opposite holds true as well. A dollar index rally back up to $104-$100 resistance coupled with a test of 2.6% in the US 10-year treasury rate likely means sell offs in EUR, Yen, Gold, Oil, and EM.* With that dollar current at support and long-term US risk free rates trading sideways, markets appear to be at an important juncture. How this all unfolds may very well influence the perception surrounding the Fed's likely path forward.*Now in the event the dollar were to resume it's prior uptrend while long-term treasury rates fell, this would signal caution. This combination is usually symptomatic of a risk-off environment. See the following two posts to explore the short-term and long-term possible scenarios.
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