Cold Winter, Warming Spring
Warmer weather and new data releases might affect future Fed monetary policy changes.
By Steve Van Order, Fixed Income Strategist
At various points last week, China, Japan, and Europe were closed, resulting in choppy overnight markets, and shifting the focus to U.S. markets. Recently data releases have finally revealed a few trends (both negative and positive), most notably that the cold winter weather had an important effect on slowing GDP growth, and that improving labor market data seems to be a sign of warmer times. In April, the ten-year T-note yield again experienced an overall medium- to low-volatility month. By close of last Thursday, bond bulls were celebrating getting to the bottom of the ten-year T-note trading range with dreams of taking it out.
On the negative side, what a drag it was getting cold. GDP grew at an annualized rate that was well below expectations. Private investment, net exports, inventories, and government all had negative contributions to GDP. Cold weather probably helped explain much of the drag from investment, but residential investment has been a drag for two quarters now and the recent housing data has been soft. Based on current private and Fed consensus forecasts, it will not be possible to hit a growth rate in the upper 2s to 3% for all of 2014, more like 2.3% (which is the average rate for this expansion). Economists are likely to revise their forecasts higher to account for a bigger spring bounce.
More positively, the recent labor market data have warmed things up a bit. Hints of warmer times emerged in the personal consumption and income data for March. But the April payrolls gains provided even more spring heat. While there were pluses (payroll gains), there were also minuses (a large drop in the labor force participation rate). So, while the unemployment rate fell, the labor force participation rate also fell to a 1970s-era level. Treasuries, especially the short-intermediate maturities, took it on the chin after these data were released. They settled down soon after, as traders learned more about the details. We think these are just the kind of data that will keep the Fed on its current monetary policy path.
In April, the FOMC slightly firmed-up its economic outlook but otherwise made very few changes to the policy statement. This Wednesday, Fed chief Yellen will testify before the Joint Economic Committee of Congress. While we do not expect anything new, we will be alert for any signs that she is shifting her position on just how much of the labor market slack is cyclical or structural. If soft labor market conditions have been more related to structural changes, then there is less room for the central bank to support it before inflation risk or policy-induced yield chasing get out of hand. So far Ms. Yellen has hewed to the more cyclical view. But some observers wonder whether it has started to shift a bit. If so she would move more toward the policy center.
We expect the Fed to update its exit strategy in light of the evolution of post-crisis thinking on monetary policy and development of new policy tools. The Fed will move to a policy strategy that controls the cost of money and away from its pre-crisis strategy, which was a hybrid of controlling the cost and quantity of money. This will mean that the Fed will not have to sell government debt holdings from the System Open Market Account (SOMA) to permanently drain excess bank reserves in order to achieve a targeted Fed funds rate. Bank reserves at the Fed, currently at $2.6 trillion, could remain elevated for the long haul.
This commentary represents the opinions of the author as of May 2, 2014 and may change based on market and other conditions. These opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information. Calvert may have acted upon this research prior to or immediately following publication. In addition, accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.