Higher Interest Rates Will Come Once These 4 Economic Conditions Are Met (+2K Views)

Four economic conditions need to be in place for interest rates to rise ahead of – and independent of – the Fed’s forward guidance. The economy met only one of those conditions to date but will likely meet all four by the end of the year…What follows is a status report on the four conditions.

The above introductory comments are edited excerpts from an article by Ashley Kindergan (thefinancialist.com) entitled The Signs of a Bond Market Reckoning.

The following article is presented courtesy of Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!) and has been edited, abridged and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.

Kindergan goes on to say in further edited excerpts:

When the 4 economic conditions, deemed to be needed according to James Sweeney, Chief Economist for Credit Suisse’s Investment Bank, happen a market that is currently pricing for a September 2015 rate hike is likely to move expectations forward.

Below is a status report on those 4 conditions.

1. Credit Markets Turn Frothy: Happened A While Ago

As of mid-July,

• high-yield borrowers paid, on average, a premium of 3.48 percentage points over Treasuries,
  • well below the already historically low 5.11-point spread at this time last year and
  • light years away from the 21.82% peak in December 2008 and
• the 5.29% average yield for high-yield bonds is the lowest it’s been in a decade.

Concerns that tight credit spreads and low market volatility might threaten financial stability prompted Kansas City Fed President Esther George to advocate raising short-term interest rates faster than currently anticipated in the Federal Reserve’s dot survey. In a July 3 speech, however, Yellen said that she sees no imminent need to tighten policy based on financial stability concerns.

2. Inflation at 2%: Just Happened

Core CPI inflation, which does not include food and energy prices, has increased steadily in 2014, from a January reading of 1.6% to 2% in May.

Credit Suisse rates strategists noted in a report last month that Yellen has waved away inflation worries for now, “calling the evidence of a rise in inflation ‘noisy,’ and striking a relatively dovish tone despite acknowledging the high degree of uncertainty a number of times.” That kind of talk, they add, puts the Federal Reserve in danger of falling behind the curve when it comes to the market’s reaction to inflation data going forward.

3. Improving Global Growth Momentum: Happening Now

Growth in global industrial production (measured on an annualized rolling three-month basis) slowed from 5.3% in November 2013 to 3.4% in June. Idiosyncratic regional factors drove the slowdown, chief among them being the twin effects of a brutal winter and inventory overhang in the U.S.

Credit Suisse’s fixed income team says improving U.S. manufacturing data and rising levels of new orders in recent PMI surveys suggest that global industrial production momentum may have troughed in June. The team expects it to accelerate through the fourth quarter, and for global GDP growth to grow 3.3% in the second half of the year.

4. Unemployment Below 6%: Should Happen By Year-End

The U.S. unemployment rate hit 6.1% in June, and Credit Suisse economists expect it will fall to 5.8% by the end of the year, a whisper away from the 5.2-5.5% range the Fed considers “full employment.”

In a June 18 press conference, Yellen said declining labor force participation rates indicate lingering slack in the labor market. If those frustrated workers resume their job searches as the economy strengthens, she added, the downward march in unemployment should slow. A recent analysis by Credit Suisse economists, however, suggests that declining participation rates are more structural than cyclical, and that even if unemployment dropped a full 1% over the next year, any resulting increase in the participation rate would be an insignificant 0.05 to 0.1 percentage points, making Yellen’s hypothetical unlikely.

Conclusion

The Fed’s dovish signals to this point are understandable. Economic activity, while improving, isn’t back where it needs to be. U.S. GDP, for example, is expected to rise just 1.5% this year, the slowest growth rate since 2009 but the doves’ days seem numbered.

As soon as next month, Credit Suisse expects the Fed outlook to become more balanced as central bankers zero in on an exit strategy from more than five years of near-zero interest rates, and once that happens, the long-awaited bond market reckoning is likely to finally make an appearance.

Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.

*http://www.thefinancialist.com/the-signs-of-a-bond-market-reckoning/ (© Copyright 2014  Credit Suisse)

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