Fixed Income Outlook  |  Q4 2017

Global growth quickens without inflation

Fixed Income Team

  • The U.S. and global economy continue to grow in a synchronized fashion that has, in past cycles, helped foster faster growth, although an acceleration is not yet clear in the data.
  • The U.S. Federal Reserve and the European Central Bank continue to move toward tighter policy though inflation readings continue to disappoint.
  • We believe fundamental conditions continue to be supportive for a variety of credit, prepayment, and liquidity risk strategies.

U.S. economic data remained positive during the third quarter and consistent with an economy growing steadily at around 2.0% to 2.5%. Our outlook is for more of the same. Beyond the United States, the global economy is growing in a synchronized fashion and firing on many cylinders. While synchronized cycles can build on themselves and there is a possibility of growth moving to the upside, we haven’t yet seen enough data to suggest that such a transition is at hand.

The trends and the events of the third quarter have not altered the trajectory that we see for the economy. The major issues remain the geopolitical confrontation over North Korea’s missile and nuclear weapons development program and its potential to disrupt trade and growth; the persistence of low inflation and its implications for central bank policies; and the developing debate over U.S. fiscal policy and, more specifically, possible actions on the debt ceiling, tax reform, and the federal budget.

The hurricanes stir up economic data and political decisions

Aside from these themes, Hurricanes Harvey, Irma, and Maria deserve mention because of the destruction and suffering they have caused and the consequences for economic data, as well as for politics. Harvey-related flooding that badly affected southern Texas has raised gasoline prices and will have some effects on headline inflation and consumer spending. Hurricane Irma’s effects are more difficult to analyze cleanly because there is relatively little industrial production based in Florida. While there will be a reduction in third-quarter GDP because of the two storms (Puerto Rico, severely damaged by Hurricane Maria is not included in U.S. GDP figures), this should be more than offset by a bigger bounce back in the fourth quarter and the first quarter of 2018, when money will be spent on reconstruction.

With regard to politics, the human suffering caused by the hurricanes has prompted a response from Washington, and in this context the painful debate on the debt ceiling and government funding for the next fiscal year has been avoided for now through a deal that pushes deadlines out to December. However, this does not mean these issues have been resolved. In our view, the prospects for growth-enhancing tax reform remain low because of the divisions in the Republican Party over these policies and the crowded agenda confronting Congress.

Central banks take steps toward additional monetary tightening

Given the positive global economic growth profile, both the Fed and the European Central Bank (ECB) seem set to move — the Fed by beginning balance sheet reduction in October and increasing rates again in December, and the ECB by outlining its plans to taper its bond purchasing program. However, much is still unclear because both central banks show a considerable attachment to the Phillips curve and the expectation that as the labor market tightens, wages ought to rise, and inflation ought to move higher. A series of negative inflation surprises in the United States call this expectation into question. Moreover, if the economy is gradually coming to the end of this phase of the cycle, and inflation pressures continue to diminish, the central banks may become frustrated in their inability to normalize monetary policy.

Inflation may be weaker than the Fed thinks

The Fed has been clear that it views the recent negative inflation surprises in U.S. data as temporary and transitory, but we find it difficult to be confident in this view. When we look at a major component of core inflation — housing — we find indications of price weakness that are difficult to dismiss as temporary. Over the past several years, the single-family and multi-family housing markets have moved closer to equilibrium as demand for housing for purchase has recovered and new rental supply has become available. As a result, pressure on rents has eased, and indeed in some places rents are now falling, and it is rents that drive the housing statistics that are used to calculate the Consumer Price Index.

With regard to lodging — a smaller component of the CPI — hotel rates have not been rising despite high occupancy. It appears that Airbnb and other online travel services have increased the supply of rental rooms quite dramatically, as if a vast number of hotels had been built very quickly, contributing to new price competition. This is a very powerful effect, and one that is difficult to dismiss as transitory.

A December rate increase remains likely while balance sheet reduction may be blunted

Given other dynamics at work, we expect inflation to move higher in the short run, and this will be convenient for a Fed that wants to hike rates again in December. Looking toward 2018, however, we expect core inflation to remain in a narrow range, at a level that is consistent with the Fed’s target, and which therefore may not warrant the three rate hikes that a majority of Federal Open Market Committee (FOMC) members projected at the September Fed meeting. Similarly, we are not convinced the Fed will make much progress in reducing its balance sheet. In October, the Fed will begin by allowing a total of $10 billion of Treasuries and agency mortgages to mature without reinvesting the proceeds, increasing this amount by $10 billion per quarter, until getting to the level of $50 billion per month. The Fed aims to bring down the amount of securities it acquired during several rounds of quantitative easing, although it has not committed itself to a target size for the balance sheet. The announced, slow pace of “quantitative tightening” means the issue of final balance sheet size will not need to be addressed for quite a while.

However, the liability that the Fed would like to extinguish — the excess reserves of commercial banks — may not be easy to reduce. Banks earn decent returns on these excess reserves, and it is not at all clear that they have attractive alternatives in which they could put this money. The Fed could try a different approach by seeking to lower the amount of cash circulating in the economy, but this may not be easy to do either. If the Fed’s liabilities do not fall, its assets cannot fall.

The ECB has a communications challenge

Meanwhile, the ECB continues to struggle with the fact that European growth has been stronger than it had been expecting and that inflation, while edging higher, remains well below the target. ECB President Mario Draghi did not use his Jackson Hole speech to preannounce any policy changes, but we know that the ECB needs to start tapering at the turn of the year. Continuing the purchases at the current pace would leave them without enough German government bonds to buy. Since the markets know that the ECB needs to begin tapering, the euro has begun to rise, creating an additional question about when the ECB will begin commenting on the euro to discourage its appreciation. The euro’s rise will likely cause concern in the ECB’s Governing Council that it is pushing down inflation without the ECB even having to taper its bond purchases. Given the appreciation of the euro so far, the ECB might be forced to play its hand somewhat differently. There isn’t scope to continue quantitative easing at its current pace, but perhaps the taper will be somewhat shallower than seemed likely in recent months.

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Beyond the United States, the global economy is growing in a synchronized fashion and firing on many cylinders.