The first estimate of first quarter GDP is out this morning and it easily cleared expectations coming in at 3.2% versus the 2.3% consensus forecast and the 2.2% fourth quarter result. The beat has its roots in another inventory increase (added 0.65% to GDP), and net exports (added 1.03%), with both likely to reverse in coming quarters. More importantly, consumer consumption at 1.2% was closer to the 1.0% expectation and well off the 2.5% fourth quarter pace. In another sign that one-off gains provided most of the first quarter beat, private sales to domestic purchasers (which factors out the volatile inventory, trade and government spending numbers) rose only 1.3%, the lowest since June 2013. That result is why Treasuries are rallying on the report with the 10-year note up 10/32nds in price to yield 2.50% and the 2-year up 3/32nds in price to yield 2.28%. Also aiding yields was the inflation reading in the report (core PCE) which was a docile 1.3% annualized versus 1.8% in the prior quarter. We go into more detail below regarding the results and what that means for the Fed and for yields in general.
As mentioned above first quarter GDP surprised to the upside and printing a 3.2% quarter-over-quarter annualized result versus the 2.3% Bloomberg consensus and 2.2% for the fourth quarter. Superficially, the beat was surprising on two counts: (1) typically, first quarter has been the weakest quarter of the year with some of the blame for that placed on “residual seasonality” which means most models are failing to capture all the seasonal adjustments, and (2) the result ended a two-quarter streak of decreasing GDP after the 4.2% high water mark in the second quarter of 2018.
One big reason, however, for the rally in Treasuries is that personal consumption, which is two-thirds of the economy came in at 1.2% versus the 1.0% consensus forecast. The result trailed fourth quarter spending of 2.5% as a strong showing in March couldn’t overcome tepid results in January and February. Consumer confidence took a hit after the December bloodbath in equities and consumers reacted by pulling back on spending but confidence returned in March after stocks staged an impressive rebound that recouped all the losses from the fourth quarter, and then some.
GDP was helped by rising inventories and a smaller-than-expected trade gap, and a surprising pop in state government spending. All those items are likely to be reversed in full or part in later quarters and that explains too some of the bullish reaction in Treasuries. While rising inventories add to GDP, if final sales of those inventories aren’t enough to draw them down, a slowdown in inventory build can be expected in future quarters. One way to eliminate the volatile impact of inventories, trade and government spending is to look at real final sales to private domestic purchasers and that number was a tepid 1.3%, the lowest since June 2013, nearly six years ago.
Yet another reason for the bullish Treasury response is that business investment rose just 2.7% versus 5.4% in the fourth quarter. The dip in spending is counter to what the Fed wants to see which is increasing levels of spending that could lead to improved productivity numbers in future quarters as businesses reinvest in new and improved equipment helping to offset the impact from increasing wage gains.
In the end, while first quarter GDP posted a solid 3.2% growth rate the Fed is not likely to move from it’s recent shift to a patient pause in rate hikes. The inventory build that has been developing since the middle of last year will eventually have to be worked off in coming quarters and that will slow manufacturing activity unless end-user spending accelerates. And while business investment was decent it did slow from the fourth quarter which means businesses remain hesitant to get fully behind the expansion at this point with productivity-enhancing investments. Thus, full-year 2019 GDP estimates are likely to remain in the 2.3% to 2.5% range. In addition, overseas economies continue to be mired in decreasing growth and the headwinds from that will be something the Fed will be keen not to aggravate with further rate hikes.
Furthermore, the Fed is facing increasing criticism that they have missed on their 2% inflation benchmark for many years coming out of the Great Recession and the trend in core PCE—their favored inflation indicator— is moving lower. The core PCE print from the first quarter was 1.3% annualized versus 1.4% expected and 1.8% in the fourth quarter. That’s why we’ve begun to hear from a few Fed officials that perhaps “allowing” inflation to run above the 2% benchmark may be beneficial in getting inflation and inflation expectations from drifting lower as well. The belief at the Fed is that inflation expectations largely determine the direction in inflation longer-term and they get anxious when those expectations start to drift too far in either direction from the 2% benchmark. Thus, the Fed is likely to remain in a patient pause mode hoping that actual inflation and expectations start to move towards, and perhaps over, the 2% target.
Thus, with the Fed likely remaining in pause mode, short rates are somewhat range-bound with a bias to rally as rate cuts are still the odds-on favorite for the next Fed move. Also, we think that with the aforementioned moribund overseas economies the lack of global growth combined with the docile inflation picture will keep longer-end rates range bound with the 10-year trying to rally below 2.50% at the moment.
U.S. Dollar Moving Higher Yet Again
As mentioned above, the U.S. economy stands apart from most of the other developed economies in the world with solid and consistent growth. Partially as a consequence of that dichotomy the dollar has been strengthening against most other currencies for the past year. With further slowing in major overseas economies (read Europe, China and Japan), the dollar is bouncing higher once again. The implications of that are: (1) continued headwinds on the trade front as exports increase in cost for potential foreign buyers, and (2) decreasing import costs will exacerbate the importation of deflation. Thus, dollar strength will be another factor in keeping the Fed on hold despite solid GDP results.
|Treasury Curve||Today||Chg Last Wk.||LIBOR Rates||Today||Chg Last Wk.||FF/Prime||Rate||Swap Rates||Rate|
|3 Month||2.41%||UNCH||1 Mo LIBOR||2.48%||UNCH||FF Target Rate||2.25%-2.50%||3 Year||2.323%|
|6 Month||2.45%||-0.02%||3 Mo LIBOR||2.59%||-0.01%||Prime Rate||5.50%||5 Year||2.321%|
|2 Year||2.29%||-0.09%||6 Mo LIBOR||2.62%||-0.01%||IOER||2.40%||10 Year||2.485%|
|10 Year||2.50%||-0.06%||12 MO LIBOR||2.73%||-0.01%||SOFR||2.45%|