CFO Focus: An Uncertain Second Half
The second half of 2018 will prove to be one of great volatility and uncertainty. Presently, the economic outlook for the U.S. and, to some extent, the global economy looks quite robust. This would portend to a continued tightening of monetary policy by the Federal Reserve, as well as an increase in long-term rates with the 10-year Treasury note going perhaps to 3.30 percent sometime in the third quarter.
However, there are serious geopolitical roadblocks developing that could derail economic growth and reduce the Fed’s pace of tightening policy later in the year. As of this writing, it appears that the issues of global trade, which flared up quite dramatically at the G-7 Summit earlier in the month, will at best, produce uncertainty and disrupt long-term business strategic planning in the second half of 2018. At the worst, these issues could significantly retard global economic growth.
First, let’s address the case for higher rates. Currently, by nearly every acceptable measure, the U.S. is at or very near what is considered “full employment.” Wages are rising as evidenced by the increase in average hourly earnings as reported by the Bureau of Labor Statistics in May. Additionally, a favored indicator for the Fed, the BLS job opening and labor turnover “quit rate” is the highest it has been in a decade. The quit rate is an indication that employees feel secure enough to leave their current job for one they consider better.
Meanwhile, the manufacturing sector is now operating on all cylinders as indicated by the May and April Institute of Supply Management reports. These reports cited new orders production and employment growing, supply deliveries slowing, backlogged orders increasing, raw material prices increasing, and imports and exports growing. The signals coming from the manufacturing sector are pointing to an economy that either already is or is ready to produce inflationary pressures. Moreover, according to the May ISM non-manufacturing report, the servicing sector is also expanding at a strong rate. The Fed just raised rates yesterday, and these factors strongly point to the Fed raising the policy rate a total of four times in 2018.
Additionally, the supply of Treasury bills, notes and bonds is growing very strongly as deficit-funded fiscal stimulus in the form of the 2017 Tax Reform reduces treasury coffers without a commensurate decrease in government spending. The plan relies on high levels of economic growth to offset the loss in tax revenues.
As the full, positive effects of the stimulus have only just started to be felt, the result from a Treasury supply perspective has been a deluge of short-dated Treasury Bills and a slow but steady increase to longer dated notes and bonds. This trend is expected to continue for the rest of the year.
Additionally, The Fed is already engaged in a mild form of “quantitative tightening” (the opposite of “quantitative easing”) as it reduces reinvestment of principal pay-downs and maturities of its $4 trillion portfolio of mortgage-backed securities and Treasury notes. Also, The European Central Bank has begun to taper its own QE program, which adds to the supply of European sovereign bonds being added to the market place. Therefore, supply will be putting upward pressure on yields no matter what the economic environment.
The case for lower rates is built around the fate of global trade. I would characterize this as a self-inflicted wounding of the economy. Perhaps, in the long run it is necessary for the U.S. to shake up its relationships with our trading partners. There are definitely areas in which our partners and competitors, through either tariffs and or subsidies, unfairly harm U.S. industries. However, we have to deal with the here and now for this rate forecast.
The discord between President Trump and our G7 trading partners at the G7 summit point to the U.S. pulling out of or seriously disrupting traditional relationships that have governed the global trade for decades. With the threat of tariffs being hurled back and forth between the U.S., its allies and its non-ally competitors like China, there is a real and growing threat to global trade. This could significantly damage global economic growth as well has put significant headwinds to the U.S. economy. History has repeatedly shown us that periods marked by protectionism lead to global economic hardship.
This leaves us with quite a bit of uncertainty. If the worst case plays out and economic growth is hampered by trade wars and political uncertainty and unrest, the Fed can always delay further tightening. However, the 2017 Tax Reform is a supply side initiative. It relies on very strong, sustained economic growth to avoid the build-up of budget deficits. The larger the deficit the more the treasury has to borrow. And the more the treasury has to borrow the more the supply of Treasury bill notes and bonds will continue to increase.
Weak economic growth compounds this supply problem. This is why we have never really engaged in a massive fiscal stimulus program that relies on borrowed money this late in an economic expansion.
Therefore, I see the path of interest rates for the second half of 2018 to be asymmetric. If we are able to avoid a full-on global trade war, I see the Fed continuing to tighten monetary policy and a 10-year Treasury rate breaking through 3.25 percent in the late summer or early fall. However, should there be a serious disruption of global trade as well as continued uncertainty, the Fed may only tighten one more time (after yesterday’s decision). However, I do not think we see much of a decline in rates simply due to the onslaught of supply.
Eric Salzman is a founding partner of Blanton Research LLP, with offices in New York and San Antonio, Texas.