The market has some first-tier economic numbers to chew on this morning in the form of the May Personal Income and Spending numbers (more on that below), but trade tariff rhetoric, global growth concerns and the ever-present geopolitical machinations are proving to be the key drivers this week. It’s interesting to note too that Treasuries managed to post solid results this week despite a heavy dose of supply in 2yr ($34b), 5yr ($30)and 7yr ($30) notes. That speaks to several things but chief among them is the concern investors are now feeling over the second half prospects for both the domestic and global economies. While 2nd quarter GDP is expected to post a robust 3.4%, and 2.8% for the year, the talk of long-run rates of 3% or better have dimmed considerably, and the trade war rhetoric and global geopolitical concerns are weighing on risk assets with Treasuries benefitting form the increased handwringing. As we close out the week, the 10-year note is unchanged on the day at 2.84%. For the week, however, the yield has dipped 6bps while the 2-year has dipped 1bp. That has the 2yr-10yr spread declining 3bps to 32bps, a new cycle low.
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With 2/3rds of the economy tied to consumer consumption the monthly personal income and spending numbers are always a key for the economic outlook. For May, personal income rose 0.4% matching expectations and beating the downwardly revised 0.2% print in April (from 0.3%). Personal spending, however, rose only 0.2% missing the 0.4% expectation and the downwardly revised April print of 0.5% (from 0.6%). The yearly MoM averages have been 0.3% for income and 0.4% for spending so a beat on income but a miss on spending in May. Real spending—adjusted for inflation— was unchanged missing the 0.2% expected gain and short of the 0.3% April increase. The results indicate that while first quarter consumption was the lowest in nearly five years, the rebound in the second quarter is occurring but may not be as strong as expected. Forecasts are calling for second quarter consumption of 3.0% annualized but given the miss in May that may be optimistic. Thus the 3.4% expected GDP for the quarter may be revised slightly lower.
Finally, the personal income and spending report includes the Fed’s preferred inflation measures. The monthly Personal Consumption Expenditures (PCE) deflator increased 0.2% matching expectations and the prior month’s print. Core PCE also rose 0.2% matching forecasts and April’s results. On a year-over-year basis the PCE Deflator rose 2.3% edging above the 2.2% forecast and 3/10ths above the 2.0% April print. The important Core PCE was up 2.0% YoY, hitting the Fed’s target level. These inflation numbers will keep the Fed on its quarterly rate hiking path assuming economic growth and financial stability survive the trade war hyperbole and geopolitical developments.
Despite the importance of the personal income and spending numbers, the market has been consumed this week with the potential risks that trade tariffs and retaliatory actions may have on growth prospects. Equity markets didn’t seem too concerned with the trade rhetoric until (a) the July 6th deadline approached, (b) foreign governments began to announce retaliatory measures, and c) anecdotal evidence from companies, ports, etc., that activity is being negatively impacted now.
In addition, comments from Fed Chair Jerome Powell in Portugal this week that his concern over the detrimental impacts of trade war maneuvers is increasing had the risk-on markets reacting by taking some capital off the table. Also, in the same Portugal address Powell admitted that he is inclined to let the labor market continue to run as the equilibrium unemployment level is probably lower than the current 3.8% rate, and that’s despite a 4.5% long-run unemployment rate that was part of the latest Fed forecasts.
The rub of all the above is a continued flattening in the yield curve with the 2yr-10yr spread dropping to a 32bps cycle low this week. If the Fed were to hike in September and again in December that spread is likely to go flat if not inverted, and that’s by year-end. The realization that we may be headed to a flat to inverted curve within six months has kept bank stocks under pressure as the obvious implication that borrowing short and lending long in an inverted curve is a recipe for losses. Also, with the predictive value of an inverted curve to call recessions at nearly 100%, as the curve moves in that direction it has kept downside pressure on bank equities.
We think the practical, measured comments from Powell noted above, and the comments from other Fed officials that they would be hesitant to force an inverted curve with rate hikes, makes a four-hike scenario in the current political and economic environment questionable. That’s why odds of a fourth hike have declined this week from 57% to 50%. If the heated trade rhetoric continues and tariffs move from conceptual to reality we think the Fed is prepared to step back from its tightening schedule. That may create something of a relief rally on the short-end and put a little steepness back into the curve and perhaps a little lift back into bank stocks.
Financials Bearing Brunt of Flattening Yield Curve
It’s been a rough two weeks for financials as flattening yield curves and trade tariff rhetoric impacts growth prospects. On Wednesday investors pulled about $40 million from the Financial Select Sector SPDR Fund extending the withdrawal streak to 10 straight days, matching the longest losing streak since 2013. The price of the ETF fell for 13 straight days through Wednesday as investors pared back bets on the sector concerned over a flattening yield curve, and increasing risks from Europe and emerging markets. The sector may get a respite after the Fed’s stress test results allow the largest banks to increase dividends and stock repurchases.