The seven-year-old economic recovery in the U.S. real GDP is one of the longest recoveries in the past 100 years. Some would argue that by this duration alone, we are due for an economic slowdown. However, real gross domestic product (real GDP) increased at an annual rate of 3.2 percent in the third quarter of 2016 according to the “second” estimate released by the Bureau of Economic Analysis (BEA). This is the largest quarterly increase in the annual rate since the third quarter of 2014. In addition, the recent trend is positive as the annual rate of growth in the second quarter of 2016 was 1.4 percent and 0.8% in the first quarter. Overall in 2016, some economic data points have shown some weakness and others have shown mixed results throughout the year. Regardless of the soft patches, the recent real GDP level and trend would not seem to indicate that the current recovery is over just yet. How much longer can it last?
More recently, the Federal Reserve’s Beige Book (Federal Reserve Bank summary and analysis of economic activity and conditions as reported by the twelve Federal Reserve Districts) release reported that seven regional Fed districts were growing at a modest or moderate pace. This is a decline from 11 Fed districts in the previous release. In November, the unemployment rate continued to decline and dropped again from 4.9% to 4.6%. However, average hourly earnings in November dropped by 0.1% which was far below last month’s 0.4% rise. Nonetheless, the annual increase in average hourly earnings growth was at 2.5%. Given the duration of the economic recovery and recent economic growth measures, where does this take us in 2017?
For 2017, mainstream economists expect that real GDP growth will continue to be moderate with most expectations around the 2.0% area for the annual U.S. real GDP growth rate. However, following the U.S. presidential election, many expect 2.0% growth to be the minimum possibility as president elect Donald Trump plans to cut taxes and spend more on infrastructure. The initial response of U.S. capital markets would indicate that these measures will certainly have a strong economic growth impact along with the possibility of higher inflation. Is it reasonable to expect that these measures will pass through Congress in full, be implemented, and have an impact on 2017 economic growth? Going back to the beginning of this article, can the length of this economic recovery continue to extend and grow even faster? Would higher interest rates counteract the economic growth boost from proposed tax cuts and infrastructure spending plans?
Throughout the first half of 2016, the U.S. Treasury curve flattened with the ten-year U.S. Treasury bond yield declining to as low as 1.37% in early July. Since that time, the ten-year bond yield has moved decidedly higher with a large portion of the increase following the U.S. presidential election. The surge in yields following the U.S. presidential election has been attributed to the anticipation of federal government tax cuts and infrastructure spending. The move upward in U.S. Treasury yields has been very substantial by historical measures with the ten-year U.S. Treasury bond yield at 2.45% at the beginning of December 2016. At the time of this writing, markets are fully expecting the Federal Reserve Bank to increase the Federal Funds target rate at its December 2016 meeting. In addition, expectations are now increasing for the possibility of at least two increases to the Federal Funds target rate in 2017 and possibly more.
Have U.S. Treasury yields finally bottomed, and are they now heading significantly higher over the intermediate and long term? Based on the recent move and expectations of federal government fiscal stimulus, there is certainly a case to be made that we have seen the low in U.S. Treasury yields. On the other hand, could such expectations be premature given that president elect Donald Trump is not even in office yet? Also, what about the current length of the recovery mentioned above and the capacity for consumer spending and borrowing to continue increasing?
Either way, the recent move in U.S. Treasury yields certainly provides a preview, if not the beginning, to the path of higher rates. Even though the low interest rate environment has now persisted for seven years, credit unions need to be highly mindful of the possibility that it could finally be over. The recent move warrants analysis of the behavior of balance sheet characteristics such as the market valuation of fixed rate mortgages, loan prepayment speeds, and mortgage refi activity to name a few. Credit unions need to continue analyzing the risks of sustainably higher rates, but continue to pay some acknowledgement to the possibility that it is a false start and the risks of that scenario. As stated in previous newsletters, there has possibly been no greater time in recent decades than the current to have a heightened awareness of the credit union’s interest rate risk profile in consideration of not only higher rates, but the possibility that the recent move is a false start.