HIGHLIGHTS OF THE WEEK

  • Despite the upward revision to first-quarter GDP growth, with the second estimate indicating a 1.2% annualized gain on stronger consumption and investment, market reaction was relatively subdued given that the overall story is largely unchanged.
  • Although investors are almost fully pricing in a June rate hike, the yield curve flattened this week as longer term growth prospects became murkier and the Fed communicated that the balance sheet unwinding process would be protracted.
  • Strength in consumption should leave the U.S. economy 3.3% larger this quarter, for an average growth of 2.2% during the first half of the year. While this is far from red-hot, it nonetheless  is enough to reduce slack and should enable the Fed to continue along its gradual rate hike path.

 

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FED MINUTES SIGNAL JUNE RATE HIKE

Despite the upward revision to first-quarter GDP growth, with the second estimate indicating a 1.2% annualized gain on stronger consumption and investment, market reaction was relatively subdued given that the overall story is largely unchanged. After another slow start to the year in 2017, economic growth appears to be rebounding this quarter, and should help to further diminish labor market slack.

That narrative was expressed in the minutes of the FOMC meeting released this week, which confirmed that participants are willing to see through the first-quarter weakness, and more robust data should be enough to justify a June rate hike. The minutes suggested some discomfort about softer inflation readings for March and April, with the Fed anticipating the upcoming inflation reports to confirm the one-off nature of the declines. Next week’s payrolls should also help mitigate further concerns should the American economy continue to produce jobs at a healthy clip and wage growth pick-up. 

Despite investors almost fully pricing in a June rate hike, the yield curve flattened this week as longer-term growth prospects became murkier and the Fed communicated that the balance sheet unwinding process would be protracted. Trump’s proposed budget released this week featured projections of a drastically reduced debt-to-GDP ratio. But the feasibility of the plan is already being contested given its generous underlying growth assumptions. At the same time, the administration’s efforts to push through health care and tax code reform are being met with significant opposition from Congress, leading bondholders to pare back their longer-term growth forecasts. So far, equity investors have remained upbeat, with stock prices recovering last week’s losses, supported by stellar first quarter corporate earnings.

Oil tumbled this week as OPEC’s extension of production cuts through to Q1 2018 fell short of market expectations. The decision comes amidst a surge in US shale production to its highest level since August 2015, keeping oil inventories elevated and having the potential to undermine OPEC’s agenda. Having said that, we expect that oil will find its footing and will end the year higher as U.S. production growth decelerates and the market rebalances.

Economic data out this week was relatively modest. Sales of new and existing homes pared back in April, after a strong start to the year. Moreover, April’s advanced international goods trade balance widened unexpectedly as the surge in imports outpaced the rise in export volumes. Ultimately, the strength of U.S. demand and a relatively elevated dollar will boost imports and hinder export growth, with offsetting impacts on U.S. manufacturers. Next week’s ISM manufacturing index will likely telegraph continued growth for the sector, albeit at a slightly slower pace. 

Next week’s income and spending data will provide information on how consumers and inflation performed during the very important handoff month of April. We expect growth in consumption to accelerate from 0.6% in the first quarter to about 3.4% during Q2. Taken together with some inventory investment, the strength in consumption should leave the U.S. economy 3.3% larger this quarter, for an average growth of 2.2% during the first half of the year. While this is far from red-hot, it nonetheless is enough to reduce slack and should enable the Fed to continue along its gradual rate hike path.

Katherine Judge, Economic Analyst

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