Yellen feels good but challenges ahead

In her speech and Q&A (including twitter) late yesterday, Janet Yellen said nothing new but seems to feel pretty comfortable with where the Fed is positioned in terms of proceeding with their exit and “allowing the economy to kind of coast and remain on an even keel.” She continued to defend the stance that “we want to be ahead of the curve and not behind it.” Our readers know how we feel about this. She also said “I think we have a healthy economy now.”

Herein though lies the challenge of the Fed: looking purely at the statistics defining unemployment and inflation, the Fed is essentially at their stated goals and should already have normalized interest rates and their balance sheet, aka, going to where the pass is being thrown. Instead of course they are only 1/3 of the way there on rates (assuming the 3% eventual fed funds target they envision) and their balance sheet is essentially still at peak size. On the so called “healthy economy,” I sure wish it was but after a 1.6% growth performance in 2016, Q1 growth may be below 1%. The auto sector is rolling over, new home sales are still below where they were in 1980 when interest rates were double digits, capital spending as measured by core durable goods orders is back to where it was 11 years ago, productivity is barely rising, student debt is negatively impacting the spending habits of Millennial’s with overall consumer spending running at a still mediocre pace, corporate America is loaded up with debt, commercial real estate is topping out with loan growth in 2016 3% below 2015 according to the MBA in today’s WSJ and savers are still suffering for their thrift which then forces the need for more saving. The US economy is just ok and is far from healthy which means that its highly vulnerable to this reduction in monetary accommodation. Right now all we have is hope that the right fiscal initiatives on tax and regulation will light the fire under the economy which I so we get and hope it does as a result.

This raises the question I get asked: if you think the US economy is still challenged, why should the Fed be raising rates and reducing their balance sheet and my only response is there will never be a good time to exit from their extraordinary policy considering how extreme it was. The distorted level of interest rates is why the US economy is growing slowly and there is almost no chance a recession can be avoided no matter when they decide to reduce the easing. Thus, they might as well get it over with sooner rather than later.

The NFIB small business optimism index in March fell to 104.7 from 105.3 in February. It’s down for a 2^nd month but is still holding near the multi year peak of 105.9 in January and is well above the 94.9 print in October. Plans to Hire rose 1 pt to 16 after falling by 3 pts in February. It was 10 in October. Those planning to Increase Capital Spending was up by 3 pts to 29, matching the December level and is up 2 pts since October. Plans to Increase Inventory fell 1 pt to 2 and that is the same level pre election. There was some cooling in the big picture expectations components. Those that Expect a Better Economy fell 1 pt to 46 but that is still well above the print of -7 in October and +12 in November. Those that Expect Higher Sales fell 8 pts to 18. It recently peaked at 31 in December and was 11 in November and 1 in October. Earnings trends were still negative but 4 pts less so to match the best level since ’06. Those that said it was a Good Time to Expand held at 22. Inflation trends remained steady with Higher Selling Prices down 1 pt but remaining in a tight range post election. Compensation plans, both current and future rose after a decline in February. Positions Not Able To Fill fell 2 pts but at 30 is still in line with its recent average.

Bottom line, it’s great to see small business confidence hold up so well BUT “most of the March data were collected before Congress failed to pass a bill repealing and replacing Obamacare” and hopes for its change was “a big reason for the soaring optimism.” Thus, the April read will be key. The NFIB CEO said “We are encouraged by signs that optimism is translating into economic activity, such as capital investment and job creation.” The fly here though and realized by healthcare was “a significant increase in the Uncertainty Index, a subset of data on how small business owners see the near term future” and “could indicate trouble on the horizon” said Bill Dunkelberg. He went on to say, “The Uncertainty Index hit 93 in March, which is the second highest reading in the survey’s history,” he said. “More small business owners are having a difficult time anticipating the factors that affect their businesses, especially government policy.” This also gets to the importance of getting tax reform done in 2017 but who knows now what can get done.

Noteworthy in Europe was the March inflation stats out of the UK. PPI input prices were up by 17.9% y/o/y vs the estimate of up 17% but that at least is some moderation from the 19.4% spike seen in February as the pound has stopped weakening. Output prices were higher by 3.6%, two tenths more than the forecast and vs 3.7% in the month prior. As for the consumer, headline CPI was up by 2.3% y/o/y, the same pace from February and holding at a 3 ½ yr high while the core rate moderated to a rise of 1.8% from 2%. As all the data was around expectations, give or take, the 5 yr and 10 yr inflation breakevens are little changed but both still well above 3% vs the BoE benchmark rate of .25%. Also compare these inflation stats with the February wage data out tomorrow that is forecasted to rise 2.2% y/o/y. Running to stand still. https://www.youtube.com/watch?v=0eCv0bXFppc. The pound is little changed but gilt yields are higher by almost 2 bps across its curve in sympathy with bond selling throughout the continent.

Investor expectations for the German economy in April as measured by the ZEW index rose to 19.5 from 12.8 last month. It’s the best level since August 2015 and above the estimate of 14.8. The Current Situation component was higher by almost 4 pts to 80.1, the best in almost 6 years. Bottom line, confidence in the German economy is high but not surprisingly. As for markets, the IFO index is more relevant as its asking actual businesses instead of ZEW which is polling investors. The euro is back above $1.06 and sovereign bond yields are rising. We are seeing more spread widening between German bund yields and with France and Italy on political worries. The German bund 10 yr yield/Italian BTP 10 yr yield spread is now at the widest level since February 2014. The Bund/Oat spread is at a 2 month high. The Euro STOXX bank stock index is near a one month low.