US Bond Market Week in Review: Rate Hikes Are Off the Table For Now

Almost immediately after the Fed raised rates, the global economy and markets tried to prove they made a mistake. Starting in early January, the Chinese market sold-off off, dragging the US market down in sympathy. The BEA originally reported 4Q15 GDP at .7% (it has since been revised slightly higher to 1%). The Services ISM dropped over two points while the manufacturing ISM continues in negative territory. Regional manufacturing indexes are showing weakness. 

Add the Beige Book to the list. While the latest release generally shows a positive economic environment, some cracks are emerging. Let’s start with the reports basic overview:

Reports from the twelve Federal Reserve Districts continued to indicate that economic activity expanded in most Districts since the previous Beige Book report. Economic growth increased moderately in Richmond and San Francisco and at a modest pace in Cleveland, Atlanta, Chicago, and Minneapolis. Philadelphia reported a slight increase in economic activity, and St. Louis described conditions as mixed. Most contacts in Boston cited higher sales or revenues than a year-ago but mixed results since the previous month. New York and Dallas described economic activity as flat, and Kansas City noted a modest decline in activity. Across the nation, business contacts were generally optimistic about future economic growth.

Most districts again over-used the adjective “moderate” to describe growth. However, St. Louis’ growth was “mixed” while New York and Dallas described economic activity as “flat.”  Philadelphia’s output rose “slightly.” All of these districts imply the 4Q weakness could be spilling over to 1Q16. 

Several facts are causing the weakness: 

Consumer spending increased in the majority of Districts, although Kansas City and Dallas noted some weakness. Auto sales were mixed, but remained at elevated levels in most Districts. Tourism activity strengthened in most reporting Districts.

Oil’s low price is negatively impacting the Dallas district, while the year-long drop in the Kansas City manufacturing index is slowing activity in that district. The description of “mixed” auto sales is consistent with the rise of incentives to lure customers into showrooms. These weaker comments are consistent with the slightly weaker consumer spending number contained in the 4Q15 GDP report (see table below).

Nonfinancial services activity grew slightly since the previous report, and demand for staffing services moved higher. Transportation activity was mixed, with weakness in the energy and agriculture sectors and lower export volumes limiting gains

January’s ISM non-manufacturing reading of 53.5 caught the markets off-guard because it implied the once strong sector was weakening.  The latest Beige Book report confirms some service sector softness, but, so far, it appears the weakness is isolated to the energy and ancillary sectors.  This week’s ISM release showed a steadying headlines number but an uptick in overall production. So hopefully, we’ll see this number inch up over the next few months.

Overall, manufacturing activity was flat, although conditions varied considerably across Districts. Most Districts noted that weak demand from the energy sector was creating a significant headwind for manufacturers, although contacts in San Francisco mentioned that low energy costs had reduced production costs for steel products. Many Districts reported that the strengthening dollar and weakening global outlook had negatively affected international exports.

Industrial production had a negative impact on the CEIs for a majority of the last seven months. The combination of the strong dollar, weaker overseaseconomies and oil’s price slide have slowed the capital goods sector.   

Residential real estate sales rose in most Districts since the last report, and home inventories were low in the majority of Districts. Residential construction activity strengthened, as several Districts noted strong growth in multifamily construction. Nonresidential real estate sales also picked up, onnet, although sales ranged from flat to strong across all Districts.

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Labor market conditions continued to improve, with the majority of Districts reporting modest gains. Wage growth varied considerably, from flat to strong, across all Districts, and most Districts reported that consumer prices held steady.

A strong jobs and real estate market combine to provide the best news for the Fed going forward.  The latest employment figures were strong; 242,000 jobs were added in February with an upward revision of 30,000 over the preceding two months.  And both new and existing home sales are still rising.

The Fed faces a slightly weaker US economy going into their next meeting. While the jobs and housing market are in decent shape, consumer spending, while still positive, is slightly weaker. Trade is having a net negative impact, as well as the oil market. Capital spending is also weak.  A rate hike is all but off the table.   

Fed President Dudley spoke to this weakness in his speech last week. He highlighted two potential problems. Weakness in several fourth quarter GDP components was the first:

In the fourth quarter, investment spending for both equipment and structures fell, and net exports and inventory investment were drags on growth. These developments partly reflect the slowing of global growth and the impact of the dollar’s appreciation since mid-2014. This weakness has been particularly evident in U.S. manufacturing. However, the latest ISM non-manufacturing index suggests the possibility of a slower pace of growth also in the services sector, which has been relatively robust. Consumer spending growth—which had been a brighter spot for most of 2015—also slowed notably in the fourth quarter.

The following table from Doug Short illustrates Dudley’s points:

Personal consumption expenditures, which contributed over 2% to second and third quarte growth, only added 1.38% in the fourth.  Investment spending dropped in 2H15; non-residential construction declined in three of the last four quarters while equipment spending subtracted from growth in 4Q15.  The strong dollar lowered exports of goods for most of 2015, while inventory adjustments lowered growth in 2H15.  Dudley notes all of these data points could simply be transitory events.  But should weakness continue through 1Q16 it’s possible an overall trend may be developing. 

Dudley next notes a decline in inflation expectations:

This continued period of low headline inflation is a concern, in part, because it could lead to significantly lower inflation expectations. If this drop in inflation expectations were to occur, it would, in turn, tend to depress future inflation. Evidence on the inflation expectations front suggests some cause for concern. In particular, market-based measures of longer-term inflation compensation derived from nominal and inflation-indexed Treasury securities have fallen to very low levels. In addition, some survey measures of household inflation expectations have recently moved lower.

The following charts illustrate Dudley’s points:

The top chart shows the difference between the 5-year treasury and 5 year TIPS.  The spread is very low.  The bottom chart shows the University of Michigan’s consumer inflation expectations index, which, while still fairly high at 2.5% is near its lowest level in the history of the data series.  Modern inflation theory places far more emphasis on inflation expectations, arguing that perception of low inflation eventually translates into weaker demand.  Assuming this to be correct, then these numbers should be concerning. 

However, there are some recent developments that might put a dent in Dudley’s inflation analysis.  First, both the US core and overall CPI have increased on a Y/Y basis:

And other measures of inflation are either moving higher or are at appropriate levels (see here, here and here).  But these developments are too recent to indicate the low-inflation trend has reversed.