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Deflation’s Persistence Implies Yields Will Be Lower for Longer

Despite what you hear from the TV pundits, the U.S.’s second quarter ended on weakness, and there is little evidence that economic acceleration occurred.  In previous years, slow GDP growth in Q1 was followed by 3%+ in Q2.  Not this time!  The Atlanta Fed GDPNow model, which uses a lot of sentiment indicators, is all the way down to 2.4% for Q2.  I suspect that the Commerce Department’s initial GDP estimate, due at the end of the month, will start out high (above 2%) and be revised downward as the guesstimates are replaced by hard data.  Here is some detail regarding U.S. economic growth as the quarter ended:
•    The headline employment report, at 222,000 for June, handily beat the consensus and reversed the poor May showing.  Yet, despite the favorable looking headline, the underlying data reveals continued softness.  As it turns out, most of the jobs created were summer jobs (16-19 year olds) or were filled by those aged 55+.  Those in their prime working years (20-54 years old) actually lost jobs;
•    The Congressional Budget Office (CBO) announced a much slower than anticipated tax revenue stream, particularly from individuals;
•    The price of oil in June fell to about $42/bbl.; it was near $52/bbl. in late May.  At this writing, it sits at $46+ with little prospect of rising above $50 anytime soon;
•    June marked the fifth month of the last six where auto sales have shown a sequential decline; and with bloated inventories (both new and used), there are deals galore;
•    Retail sales, excluding food services, don’t look much better.  May and June showed the first back to back declines in nearly two years;
•    Even consumer sentiment is flagging, down to 93.1 in July (University of Michigan) from 95.1 and 97.1 in June and May respectively;
•    Both March and May showed negative changes in the Consumer Price Index (CPI), an unusual phenomenon outside of recessions. June was flat.  Removing the volatile food and energy components, the core index peaked last August at 2.3% and has fallen in seven of the last nine months, and for the last four in a row, currently standing at 1.7%;
•    Housing, usually the industry to lead the country out of recession, has done anything but.  Outside of recessions, you have to go back to the 1960s to find a slower housing (new construction and sales) industry.

Negative QE
On top of the economic weakness, the Fed continues on its tightening path.  There are two aspects of the Fed’s program: the most well-know is the raising of short-term interest rates; but the more important one is allowing assets in its portfolio (currently about $4.5 trillion, up from 0.9 trillion at the end of ‘07) to run-off.  Since this is the exact opposite of the original Quantitative Easing (QE) policies of the Bernanke years, let’s call it “negative QE.”
The major impact of the Bernanke QE program was asset price appreciation (equities and real estate) to provide a “wealth effect” for the economy.  The impact of negative QE has to be just the opposite.  The Fed has promised a go-slow approach at the beginning with the negative QE program expanding as time goes on.  But, it is inevitable that a negative QE program will put continual downward pressure on asset prices, with the level of downward pressure dependent on the magnitude of the run-off (slow at the beginning and then accelerating).
The other aspect is the rate hikes which are what the business media concentrates on.  These are really quite dependent on inflation, and the Fed has been anything but correct about the level of inflation.  Just look at the dismal track record they have on attaining their 2% inflation target.  In the last 105 months (September ’08 through June ’17), the Fed has hit its inflation objective of 2% in only four of those 105 months.  As a result of low inflation, rate hikes may come along at a slower pace than previously anticipated.
The Inflation Boogeyman
At her recent Congressional testimonies, Fed Chair Yellen appears to have backed off the hard line she had previously taken regarding rate hikes.  But don’t be fooled.  The stealth tightening here is in the negative QE; not so much in the rate hikes.  As I have discussed in previous writings, a policy of continued monetary tightening, at the end of the business cycle and into an anemic growth rate, is a sure fired formula for recession.  I don’t know what Yellen & Co. are seeing to come up with a 2% inflation forecast “sometime next year,” but it sure isn’t anything I can find!
Conclusion
The evidence is that deflationary pressures are not “transitory” as Yellen has opined.  In fact, the inflation models run by both the Cleveland and Dallas Federal Reserve Banks show significant and persistent downward pressure on prices.  This persistence means 1) a continuation of low interest rates as far as the eye can see and 2) when we get the occasional run-up in longer-term yields, as we have recently, it is a buying opportunity, especially for those in or approaching retirement.  It is unprecedented that in the ninth year of this expansion, yields remain at historic lows.  Consider how low they might go in the next recession!

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