Economic Commentary

Our current monthly tabulation of estimates from key economists indicates a sizeable improvement in economic growth projections--from a forecast of negative annualized growth of 1.98% in the second quarter, to positive growth of 1.62% in the third quarter. Last month, our barometer was calling for third-quarter GDP growth of only 0.98%.

In order for the third-quarter outlook to improve, government stimulus will clearly need to compensate for lethargic consumer spending, capital investments, and weakening exports. There is really only component of the “CIGX” formula as it relates to the sum of GDP* that can turn the tide for now. Why? Household deleveraging still needs to play out in the wake of: (1) $13 trillion in diminution of equity and housing wealth; (2) a household savings rate that remained in the 0% range for much of 2007 and 2008 and is only beginning to recover; (3) uncertainties associated with a rising unemployment rate; and finally, (4) consumer spending having recently peaked at 75% of the total economy (versus roughly two-thirds of the economy a generation ago).

The good news is that, thanks in large part to government spending, there is a marked improvement in many financial indicators. Myriad reasons for this improvement were cited by President of the Federal Reserve Bank of San Francisco Janet Yellen, when earlier this week she stated that strong performance of the stock market in recent weeks, improvement in short-term liquidity metrics, a leveling off of home sales deterioration (the S&P Case-Schiller home-price index increased 0.5% during May, which represented the first monthly gain in the index since July 2006), along with signs that the erosion in consumer spending is stabilizing.

Dr. Yellen echoed Chairman Bernanke’s view that the current economic climate will not make inflation a great concern for an “extended period.” Both have deflected the issue of mounting deficits, stating that the deficits are likely to be substantially temporary (e.g., as tax collections fall, stabilizers such as unemployment insurance kick-in), while still asserting that structural deficits (i.e., precipitated by Social Security and Medicare) remain a concern if not addressed in the future. As such, Dr. Yellen inferred that the market’s perception of our ability to inspire confidence in solving the structural portion of the deficit could remain the wild card. In spite of present-day economic indicators suggesting continuation of loose monetary policy, we always need to be reminded that we live in a world where perception can rapidly become reality!

On that note, the spread between two-year and ten-year Treasuries is now in excess of 250 basis points. In looking at spread history since 1991, we observe only two other points at which spreads exceeded that amount: one in 1992, and one in 2003. This historical observation might lead one to conclude that some degree of yield curve flattening might follow. In 1992, a Fed rate hike followed 18 months after the peak in August; in 2003, it occurred 10 months following the peak, which occurred in August as well.

So, you might be best advised be on guard for subtle remarks from the Fed that could lead to flattening, perhaps in the form of a “bear-steepener.” You may want to be more asset sensitive than you are at present and may evaluate if your asset and liability durations make sense for this type of contingency.

* GDP = (Consumer Expenditures)+(Capital Investment)+(Government Spending)+(Net Exports/Imports)

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