Economic Commentary

This month, we’ve subtitled our commentary “Back to Reality” or “Wilting of the Greenshoots.”

When we left off a few weeks ago, the non-farm payroll number was still declining. Even so, the markets had interpreted the below-estimate jobs-lost figure of 200,000 as a sign that the economy was beginning to right itself. A lot has happened to economic estimates and the yield curve since then.

Let’s first look at the Fed Funds Implied Probability Index and the probability that the Fed will have boosted the target rate to 1.00% before the December 16, 2009, FOMC meeting. When employment statistics were announced on June 5, the probability was 28.1%. Today, it is zero.

We have also seen a few changes in the select group of economic estimates that we track.

  • Notwithstanding the Administration’s admission that the unemployment rate will surpass 10.0% later this year, third-quarter unemployment levels are expected to reach 9.7%.
  • The 10-year Treasury, which yielded 3.95% on June 10, has settled down to yield 3.62%, in spite of the fact that the Treasury will be auctioning a record $278 billion of debt over the next two weeks.
  • Fed funds estimates are virtually unchanged from current negligible levels.
  • Predictions of the second quarter’s GDP decline have been toned down. Last month’s median estimates were calling for a decline of 2.72%. The latest estimates show a decline of 2.20%. Nonetheless, this week the World Bank revised its previous estimate for global economic decline, from 1.70% to 2.90%. Still, with all of this downbeat news, there is one positive indication that one of the U.S.’s structural imbalances, the current account, is improving. At 2.9% of GDP, it is at its lowest level since late 2001, primarily due to declining imports.

The Fed statement issued on June 24 was scrutinized for any changes to language from the statement issued after the April meeting, which cited “exceptionally low levels of the Federal funds rate for an extended period.” Was there any watering down of this phraseology, which might foretell an earlier-than-expected tightening? It does not appear to be so. We also were watching for signs of any changes in quantitative easing, checking to see if the Fed has been buying long-term Treasuries and agency MBS. As we saw with the 10-year’s earlier flirtation with a 4.00% yield, the international capital markets will likely hold more sway than will open market purchases by the central bank.

The yield curve has also altered its mid-section by just a bit over the past few weeks. Our yield curve optimality break-even analysis, a forward yield curve analysis presented in each month’s issue of What Counts, provides an interesting guide for those considering funding extensions. Think about this: The so called break-even rate rise, as measured by two-year advance rates, increased from 123 basis points to 175 basis points, while the break-even rate rise statistics in the four- and five-year area remained relatively constant. This means that there is a decreasing benefit to borrowing in the two-year sector. This phenomenon seems consistent with the view that the amount of liquidity that the Fed is injecting into the economy will ultimately terminate in an “exit strategy.” That exit strategy could take the form of Fed tightening, which begs the question: Do you want to set maturities in a forecasted timeframe in which the Fed is thought to be tightening? Remember, if you’re looking at this variable as an investor, invest in the two-year sector as opposed to further out on the curve.

As we travel throughout the 12th District, the common lament seems to be how to invest increased liquidity into viable asset classes. For awhile, municipals appeared to be a good target. Of late, however, muni prices have increased due to such technical factors as a decline in year-to-date issuances by approximately 18% and growing municipal fund demand in anticipation of forecasted increases in tax rates. Spreads to Treasuries are closing back to levels last seen during the great liquidity crisis of the fourth quarter of 2008. Since then, the 10-year muni/Treasury ratio has declined from 180% to 85%.

If you’re of the persuasion (and many are) that 10-year yields were deservedly approaching 4.00% because of sizeable deficit increases and the temptation to re-inflate our way out of the housing bust, you may wonder if holding on to real estate assets might not be a bad strategy over the long haul—to the extent your pressure to de-lever allows! So, let’s look at just a couple of inflation proxies.

  • First, you can look at the difference between 10-year Treasuries and TIPS, or inflation-indexed bonds. That spread remains at a historically benign level of 1.90%, although it has widened by about 40 basis points in the past month.
  • Second, the inflation swap market is now implying an inflation rate of 2.6%. And why not? Capacity utilization is a paltry 68%. Indeed, the Fed asserted in its recent minutes that “substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.” This is small solace amid a rapidly growing money supply—not just in the U.S., but throughout the world. The real picture will emerge once the Fed is required to shrink its balance sheet, at the onset of a recovery, in order to stave off inflation. That’s referred to in some circles as the “exit strategy.” That mains a source of uncertainty, as reflected in the relatively poor total rate of return on Treasuries, with the Merrill Lynch U.S. Treasury Master Index having declined by 5% so far this year.

From a funding perspective, you might want to consider several moves, in addition to extending into the four- to five-year sector. These include taking advantage of the Seattle Bank’s Community Investment Program (CIP) and Economic Development Fund (EDF), which offer rates of approximately 30 basis points less than posted levels, and considering advances with forward rate-setting features.

By John P. Biestman, CFA is director of business development at the Federal Home Loan Bank of Seattle.