You know the economy must be slowing when even the chairman of the Federal Reserve is admitting it to a room full of the world’s most powerful people in finance. Just parsing Ben Bernanke’s speech to the International Monetary Conference on June 8 reveals a negative outlook for the U.S. economy.
Bernanke said, "U.S. economic growth so far this year looks to have been somewhat slower than expected…A number of indicators also suggest some loss of momentum in the labor market in recent weeks." In Fed-speak, that’s pretty bad.
While 2011 began with a salew of positive numbers that had many analysts hopeful that the tepid recovery was gaining steam, more recent numbers have turned those expectations south in nearly every part of the economy. "At the start of the year, the U.S. economy looked like it had pretty much everything going for it," says Paul Dales, senior U.S. economist at Capital Economics. "Six months into the year, we’re back to the situation where the economy is only growing about 2% a year. We’ve gone from hope that we would see a decent performance, back to general expectations that things are going to be weak for quite a while."
Jim Barrett, senior market strategist at Lind-Waldock, also doesn’t see things picking up in the economy any time soon. "People may be a little overly pessimistic about the economy right now, but it’s hard to see an uptick that really would threaten note and bond prices," he says. Barrett expects yields on the 10-year to stay below 3%, working down to 2.80% and possibly 2.75% if the stock market really gets bad. That’s a trading range of 123-00 to 126-50. He expects the 30-year bond to be a bit more volatile with a trading range of 125-00 to 129-50 through the summer.
Brian Edmonds, senior managing director and head of interest rate trading at Cantor Fitzgerald, expects Treasuries to remain strong despite QE2 ending in June. Edmonds says bonds and notes have rallied this spring because of poor economic numbers and any weakness from the end of QE2 would be offset by the Fed’s pledge to continue reinvesting principal payments from its securities holdings.
Edmonds says there is an outside chance of a QE3 if the economy does not improve, but doesn’t expect that to happen immediately following the end of QE2. "There will be a lag time," he says.
By nearly every measure of the economy, the outlook has turned negative since the beginning of May. This is true in housing, jobs reports, GDP projections and interest rate expectations. Naturally, many of these are related.
Straw houses
The phrase "double-dip" made its way back into economic analysis in late spring as the S&P/Case-Shiller Housing Index dropped to 138.16 and took out the bottom recorded in April 2009 of 139.26 (see "Bottom dropping out"). With this came news that home prices nationally had retreated to levels last seen in 2002, and some markets falling even further.
In most recessions, housing is one of the first areas to pick back up and begin contributing to GDP, but that hasn’t been the case this time. Dales says that two years into other recessions, residential investment or home building has contributed about 1% to annual GDP growth, but in the last two years it has contributed nothing. Obviously this recession is different as the bursting of a housing price bubble was the underlying cause.
Bernanke agrees that housing has been a drag on the recovery. "The housing sector typically plays an important role in economic recoveries; the depressed state of housing in the United States is a big reason that the current recovery is less vigorous than we would like," he said in his speech to the International Monetary Conference.
There is a glut of bank-owned homes and short sales on the market. "[Foreclosures] are hurting housing now because those are existing homes that need to be sold before new houses can be built," says Keith Springer, president of Springer Financial Advisors. "Without a housing industry, which is a huge part of our economy, it is going to be a drag on our economy for years to come."
In addition to foreclosures and short sales flooding the market, there is an unquantifiable amount of shadow inventory. "It is presumed that if there would be any sign of prices lifting or even stabilizing, then there are a lot of people out there who would want to go ahead and sell their house," says Spencer Patton, chief investment officer at Steel Vine Investments. "That kind of specter is really not going to be good for prices."
As a result, analysts expect housing prices to continue to fall at least through this year and possibly through part of next year. Demand isn’t expected to begin increasing until 2014-2015. "After the Great Depression, it took 19 years for housing prices to retrace to pre-depression levels. That’s where we are now," Patton says.
One of the most supportive factors for housing has been the low interest rate environment and this especially was true once the 10-year U.S. Treasury bond dropped below 3% yield on June 1. "In a normal economy, that would spur the housing market. In this economy, it is not the price of borrowing that is holding back the housing market, it is the inability of people to get it," Dales says. He expects the Fed to keep its policy rate near zero for another couple years and sees the 10-year bond dropping to close to 2.5% yield by the end of the year.
Springer has comparable expectations, assuming there isn’t another round of quantitative easing around the corner. "You’re going to have slower growth because of lower government spending. Lower growth means lower inflation. You add in fiscal responsibility and you have low yields," he says. Springer expects to see 2.50%-2.75% on the 10-year and 3.50%-3.75% on the 30-year by the end of the year. On Treasury futures, that translates to the 129-00 to 130-00 area in the long bond and the 127-00 to 128-00 area in the 10-year, a multiyear high. Edmonds points out that the Fed has pushed back any possible tightening to help housing but cautions, "They can’t just keep rates down [forever]."
He acknowledges that Japan has kept their rates near zero for more than a decade but adds that more of Japan’s debt is held by domestic investors whereas U.S. debt is held by foreign countries. "Our risk is higher," Edmonds says.
Hi-ho, hi-ho
Like the housing market, employment took a surprise hit in May that had economists questioning the strength of the recovery. While we had seen strong job growth throughout the first half of the year, May non-farm payroll came in at a paltry 54,000 jobs, which was off economists’ expectations by more than100,000.
"Normally by this point in a recovery, we should be seeing payroll growing by 250,000-350,000 a month and the unemployment rate falling quite rapidly," Dales says (see "Will work"). "We have had some indications that job growth is doing OK, but it looks like the slowdown in economic growth that began earlier this year is prompting some companies to hold back on hiring."
Patton points to the Japanese earthquake and high commodity prices as prime suspects for the slowdown in hiring.
While unemployment dipped below 9.0% in the spring, the recent disappointing reports pushed it back above 9%. A bifurcated recovery especially has become evident over the months since QE2 was initiated. We’ve seen what many analysts are calling a jobless recovery where stocks have done particularly well, but consumers and Main Street have continued to struggle.
This is creating a new equilibrium in the marketplace where companies increasingly only are producing the goods and services they know will be absorbed by demand. "Stocks go up based on earnings, and earnings are going to continue to do well because companies can produce fewer goods with less people and still be profitable," Springer says.
The result has been Bernanke’s hoped-for wealth effect where Americans who own stocks feel richer because they have seen their equities increase in value. As a result, these people have begun spending more as is evident in the last round of earnings reports where companies such as Macy’s and Saks Fifth Avenue did well, but Walmart and Target underperformed.
With QE2 finished and stocks reversing, patterns are emerging that are very similar to last year when the first round of quantitative easing came to an end. Regardless, most analysts seem to think it is unlikely the Fed will initiate a third round.
"The Fed is having a problem with a full-blown QE3 because of diminishing returns. Each time you do it, you get a little bit less, so you get to a point where it’s not even worth doing. That’s where we are now," Springer says. "The best way to get the economy back on track is to let the economy settle into a new equilibrium. All quantitative easing does is create artificial demand and puts money into the system that shouldn’t be there."
While Bernanke did not mention further easing in his speech to the International Monetary Conference, he did say the recovery cannot be considered established until we see "a sustained period of stronger job creation." Further, although he said accommodative monetary policies cannot be a "panacea," he did say the Fed will continue to reinvest principle payments in its holdings.
This is a sign that an exit strategy is still months away because this will need to end before the Fed could consider tightening.
Stunted growth
Gross domestic product (GDP) growth deteriorated last quarter as well. While there was 3.1% of growth in the fourth quarter of 2010, that was slashed to only 1.8% in the first quarter of 2011.
"[Most of the drop in GDP] can be tied to the rise in commodity prices. There were a couple [of] other temporary factors, such as weather that was unusually harsh in the first quarter," Dales says. "Now that commodity prices have stopped rising and started falling, there may be a near-term boost to growth." Whatever growth we may see, Dales expects it to be short-lived and sees the United States back to 2% annualized growth by the end of the year.
Analysts have been discussing when the 30-year bull market in Treasuries will end, but bond prices have been tied to the Fed’s exit strategy, which has been discussed for several years and delayed just as long (see "When will it end?"). While it is true that no market move can go on forever, no one is in any hurry to start raising rates, and with the entire Western world deeply in debt, Treasury yields likely will be low for some time to come.
According to Jack Broz, founder of TradeBondFutures.com, inflation worries earlier in the year that have subsequently subsided are a driving force in the battle between bond bulls and bears. "The run-up is the bulls inflicting as much pain as they can on the bears. Earlier this year inflation was being talked about quite a bit and short positions inevitably were set. But that talk has died out for now, so we get this type of market where the bulls just punish the shorts," he says. Broz also says ongoing European sovereign debt concerns are reinforcing U.S. bonds as the best out there.
Broz says the pivotal price on the 10-year Treasury note is 120-00. As long as price stays above 124-00, he is targeting 125-25 and 126-27. If price falls below 120-00, Broz is watching for 118-00 and 117.15, where yields would race higher.
As bad as many of the numbers sound, there is still growth. What’s important to take away is that although it is slow going, we are in a recovery. "There’s going to be a recovery, but it’s not going to feel like a recovery," Springer says. "It’s going to be like a hangover. If you party for 20 hours, you might have 12 hours of a hangover. We partied for 20 years, so we might have four or five years of a hangover."
