Bond Markets & Research

• Market Update
• Newsletter
• Research
• Resources
• Treasury Yield Curve

Economic Update

Written by Jane Caron, CFA, Chief Economic Strategist

While the official arbiter for economic cycles has yet to call the date the Great Recession ended, we believe it happened last June. More importantly, we believe the recovery that took hold during the second half of 2009 will not only be sustained, it will accelerate. Real GDP growth should average about 3.5% in 2010 as the natural forces of the business cycle (pent-up demand and inventory rebuilding, in particular) encourage an acceleration in already-formed positive economic feedback loops.

Our forecast is notably above the Bloomberg consensus forecast of 2.6%, yet we still worry that our forecast is too low given the lagged effects of large-scale fiscal and monetary stimulus and no signs that policymakers are anxious to withdraw it. Indeed, additional fiscal stimulus is likely to be forthcoming, and there are members of the Federal Open Market Committee (FOMC) who believe the Fed may need to extend its large-scale asset purchase program beyond the planned March termination date.

The fact that Washington is still willing and able to extend stimulus is one of the key reasons that we are sanguine about the risks of a sharp deceleration or dip back into recession this year. The Fed is well aware of the high costs associated with a double-dip in growth or extended deflation, so we think the FOMC is operating with an inflationary bias that will remain in place until the Fed is confident that downside risks to growth and inflation are manageable. Congress, meanwhile, is very worried about high unemployment. Indeed, Washington seems far more concerned about the economy's near-term growth prospects (and the November election) than the medium-term consequences of running massive fiscal deficits.

Central to our forecast that real GDP growth will accelerate at an above-consensus rate are the following assumptions: (1) we are not headed into another jobless recovery; (2) the personal saving rate will rise by only a modest amount; (3) business investment spending (apart from structures) will rebound; and (4) the housing market will remain in a recovery mode. We should mention that we are also counting on Lady Luck to keep exogenous shocks at bay. For example, significantly higher commodities prices, natural or unnatural disasters, or a major breakdown in the symbiotic relationship with China could all wreak havoc on the economy and markets. Major policy mistakes could also occur given that massive public support will begin to be removed this year.

A recovery in the labor market is central to a sustained economic recovery. Almost all economists agree that the labor market is steadily improving, but there are mixed opinions about where it will level off. Some economists look for a repeat of the last two recoveries, which were essentially jobless—payrolls were either flat or down in the first year of recovery—while others look for the more typical, V-shaped rebound. Our view is that companies will seek to operate as leanly as possible, but they will still hire at a rate that lifts payrolls by 1–1.5% as final demand picks up near a 3% rate. Hours worked should expand at a faster clip than payroll growth because current staff will be asked to work longer hours to meet increased demand. Our forecast is well short of a "V," but it should generate enough income to support both real consumption growth of about 2–2.5% and a small increase in the saving rate.

While it was a very sharp decline in consumption that initially dialed up the severity of the recession, it was the ensuing collapse in business investment that caused GDP to contract by nearly 5.5% in the final quarter of 2008 and 6.5% in the first quarter of 2009. During this period, companies slashed investment and labor at staggering rates. Now that capacity utilization is rising again at a fairly rapid clip, we look for a rebound in capital goods spending. Investment in structures, however, should remain weak as the lagging commercial real estate correction continues to unfold.

Residential investment spending should continue to improve in line with a sustained recovery in the housing market. Quite simply, residential investment spending is extraordinarily low from a historical perspective, and this sector is bouncing off the bottom. Public efforts to support the housing market have been unprecedented and are largely to thank for the recovery. Some economists are concerned that the withdrawal of public support will upend the recovery, but we believe moderate growth will persist as long as market interest rates do not rise by a lot more than we expect.

Long-term interest rates have remained low despite shockingly high Treasury issuance because of strong demand from the Fed, foreign central banks, U.S. banks, and other domestic investors. In 2010, the Fed will drop out as a major buyer, but most other sources of demand should stay in place. Treasury coupon supply will increase significantly, however, and this should result in higher interest rates. For example, we expect 10-year yields to rise by more than 100 basis points and approach 5% in 2010 despite slowing inflation and a still highly accommodative Fed.

We look for core consumer inflation to average about 1% in 2010 compared to 1.5% in 2009. While it is impossible to accurately gauge the extent of resource underutilization, it is safe to say that it is massive. Thus, we doubt that 2010 will be a year of marked acceleration in either cost-push or demand-pull inflation. We are a bit concerned, though, about the potential for rising inflation expectations given alarming trends on the fiscal front and efforts by Washington to inhibit Fed independence. Other potential sources of pressure on inflation expectations include risks for renewed dollar weakness and rising commodities prices. The Fed itself could push inflation expectations higher if its policy stance appears to be incongruous with economic activity.

The Fed is now challenged with the task of normalizing monetary policy without overly disrupting the recovery. While the Fed has repeatedly stated that it has the tools to do this, it is clear that the Fed is not entirely sure about how and when to use them. The numerous back-stop liquidity programs can simply be wound down and terminated as they are no longer needed, but the huge amount of excess reserves remaining on the Fed's balance sheet cannot be dealt with as easily. New programs such as large-scale reverse repos and a term deposit facility are being designed to lock up reserves, but the only way to extinguish reserves in a timely manner is to sell assets on the Fed's books. That could cause long-term rates to shoot higher, so the Fed is unlikely to use this tool anytime soon.

We believe the Fed will seek to gain better control of excess reserves during the second quarter. If it is successful, then it will have more time to adjust policy in a gradual fashion, and that would bode well for a sustained expansion. As part of the gradual return to normalcy, we expect the Fed to start lifting the target funds rate this year by 125 to 150 basis points. There are significant risks around this call, however, because this forecast depends on a host of variables, including employment trends, private credit creation, inflation, fiscal policy, and market conditions.

It is the outlook for fiscal policy that is the most uncertain variable in the list. So far, Washington has not even started to put together a credible plan to reduce the pace of debt accumulation. The federal fiscal deficit, after rising from 3% of GDP in 2008 to 10% in 2009, should remain near 10% in 2010 and will unlikely fall below 5% in the foreseeable future. Federal debt, meanwhile, is on track to rise from 41% of GDP in 2008 to 55% in 2009 and 75–100% by 2020.

While we could write pages about the fiscal situation, suffice to say that we can be sure that taxes will be headed higher…much higher. In fact, one of the key risks for the economy after 2010 is a marked deceleration in growth in reaction to higher interest rates and tax burdens. That story we will save for the future, but you can be sure that this subject will be on investors' minds later this year. Thus, one should enjoy these early months of 2010 while the Fed and Washington are still focused on supporting the economy rather than cleaning up their bloated balance sheet.