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  Fed Ends QE, Rate Hikes Now on Radar
Posted Under: Government • Research Reports • Fed Reserve • Interest Rates

 
We count five key takeaways from today’s policy statement from the Federal Reserve.

First, the Fed clearly raised its assessment of the economy.  Most notably, it deleted its long-standing reference to “significant underutilization” in the labor market, changing it to say that the underutilization in the labor market is “gradually diminishing.”  This may not seem like much, but at the Yellen Fed a better assessment of the job market is a necessary step before raising rates and that hurdle is now much closer to being cleared. In addition, the Fed strengthened its language on consumer spending and completely deleted a reference to fiscal policy restraining economic growth.   

Second, quantitative easing is finished by the end of the week, as previously projected.  This doesn’t mean the Fed’s balance sheet will suddenly go back to normal.  Instead, the Fed will keep reinvesting principal payments from its holdings to maintain the balance sheet at roughly $4.4 trillion.  Look for the Fed to keep reinvesting principal through at least late 2015.

Third, the Fed is taking a more nuanced view on inflation, comparing market-based measures (such as the five-year forward inflation rate), which have diminished recently, to survey-based measures, which have remained stable.  The Fed pointed out that energy prices should hold inflation down in the near term but inflation should still head back up toward its target of 2%. 

Fourth, the Fed maintained its commitment to keep rates at current levels for a “considerable time,” but added language saying rate hikes could happen sooner or later depending on how closely actual economic data match its forecast.  We think this means the Fed is getting very close to removing the “considerable period” phrase.  Look for the Fed to remove the language at the mid-December meeting, when Chairwoman Yellen will have a chance to fully explain the Fed’s reasoning at the post-meeting press conference.     

Last, the two hawkish dissenters at the September meeting are now back on board with Fed policy while the lone dissent at today’s meeting was a dovish one from Minneapolis Fed president Narayana Kocherlakota, who wants the Fed to commit to keeping rates low until inflation hits 2% and wants to keep quantitative easing going at the current slow pace at least through the end of the year. 

The bottom line is that the Fed has been and will remain behind the curve.  We believe the first rate hike could come in the second quarter of next year.  But nominal GDP – real GDP growth plus inflation – is up 4.3% in the past year and up at a 3.8% annual rate in the past two years.  A federal funds target rate of nearly zero is too low given this growth.  It’s also too low given well-tailored policy tools like the Taylor Rule. 

In the meantime, hyperinflation is not in the cards; the Fed will keep paying banks enough to keep the money multiplier depressed.  But, given loose policy, we expect gradually faster growth in nominal GDP for the next couple of years.  In turn, the bull market in equities will continue and the bond market is due for a fall. 

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Posted on Wednesday, October 29, 2014 @ 3:34 PM • Post Link Share: 
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  New Orders for Durable Goods Declined 1.3% in September
Posted Under: Data Watch • Durable Goods

 
Implications: Don't fret much about the soft headlines on orders for durable goods in September. An upward trend is still intact. New orders for durable goods dropped 1.3% in September, falling for the second consecutive month. But once again the drop was led by the very volatile transportation sector which fell 3.7%, mainly due to a large decline in civilian aircraft orders. This kind of monthly volatility is why it’s important to look at the trend, which remains upward. Orders for durables are still up a Plow Horse-like 3.3% from a year ago and up 7.3% excluding the transportation sector. Meanwhile, shipments of “core” capital goods, which exclude defense and aircraft – a good proxy for business equipment investment – declined 0.2% in September. Still, these "core" shipments are up 7.1% versus a year ago, and were up 11.1% at an annualized rate in Q3 versus the Q2 average. As a result, it still looks like business investment in equipment grew at about a 14% annual rate in Q3 and real GDP (for which we will get the first reading on Thursday) grew at close to a 3% rate. In other manufacturing news this morning, the Richmond Fed index, a measure of factory sentiment in the mid-Atlantic region, boomed to +20 in October from +14 in September, the best reading since December 2010. This signals continued gains in industrial production in October. On the housing front, pending home sales, which are contracts on existing homes, increased 0.3% in September, and are up 3% from a year ago. Meanwhile, the national Case-Shiller home price index increased 0.4% in August and is up 5.1% from a year ago. Price gains in the past year have been led by Miami, Las Vegas, and San Francisco. The three cities with the slowest gains in the past year have been Cleveland, Charlotte, and Chicago. We expect home prices to continue to rise in the year ahead but at a slower pace than the past couple of years.

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Posted on Tuesday, October 28, 2014 @ 11:14 AM • Post Link Share: 
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  Better Policies on the Horizon
Posted Under: Government • Monday Morning Outlook • Spending • Taxes
Some say we have a Plow Horse Economy because economic growth is always slow after a financial crisis. But the real reason is that politicians from both major parties keep throwing more government “solutions” at problems. This started well before President Obama took office.

The Bush Administration, and a spend-friendly Congress, pushed temporary “stimulus” spending in 2001 and then followed Larry Summers’ Keynesian advice in early 2008 and passed tax credits and even more stimulus. President Bush said, “I’ve abandoned free market principles to save the free market system” in an explanation of TARP. Then, we got more “stimulus” in 2009. Don’t forget quantitative easing, either.

We believe this is the reason real GDP growth during the current recovery, averaging 2.2% per year, is the slowest five-year period of growth without a recession in the last 100 years.

What’s interesting is that we can divide this economy into two parts – a “Race Horse” exists in many sectors, like fracking, and high-tech; like 3-D printing, the cloud, smartphones and apps. Government did not drive these processes and new techniques; free markets did.

But, where government interfered in the most overt ways – in labor markets and in housing – the recovery has been much slower. And government is using the Amazon model of "spend to grow" in alternative energy production, hoping that losses today equal benefits tomorrow. This may be true, but at least Amazon is spending its own money and the stock market votes every day on whether it is a good idea or not.

To some, what we have just written sounds overly political. But we are actually thinking economically. We believe in small government because smaller government creates a more dynamic private sector with higher standards of living.

And, judging by the evidence, the American people are beginning to shift toward this view again. A recent Politico poll, weighted equally between Republicans and Democrats, showed 64% think things in the US feel “out of control.” Other polls show both the President and Congress with extremely low popularity right now.

It’s a 1970s vibe! Many Americans worry their kids will be worse off. They fret about ISIS and Ebola. Most Democrat candidates are allergic to President Obama showing up in their states or districts. The same was true back in 2006 when Republicans distanced themselves from President Bush.

Obviously, problems often stretch out longer than we think they should. But, it seems clear Americans are ready for a change, and when this happens, politicians start moving that way even if they don’t have strong ideologies. As an example, some are campaigning as “Clinton Democrats” these days – meaning that tax cuts and more moderate, even free market, policies aren’t off the table.

We aren’t projecting another Ronald Reagan. But a shift away from supporting “government solutions” to all problems seems more likely these days.

Next weeks’ mid-term elections are the first step, but major changes won’t take place until after the 2016 presidential election. Already there is more centrism on economics.

Years of sluggish growth have weakened the “status quo” faction inside the GOP. No wonder two of the GOP’s toughest Senate races this year are in Kentucky and Kansas where long-term incumbent Senators seem out of touch. And for Democrats, the burden of majority means they have to defend more incumbents – a tough row to hoe in a 1970s-like environment.

What this means is that a Republican president in 2016 would likely use special budget procedures to reform Medicare and Medicaid in addition to improving the tax system for both companies and individuals. But, right now a Democrat president looks more probable. And in 2017-18, with the recovery aging, she would likely support moves to reform the corporate tax code, plus reforming Obamacare with market-friendly changes like health savings accounts.

In other words, the next president is likely to be more market friendly than the current one. The American people won’t have it any other way. Look for evidence of this shift as the results of the mid-term elections pour in next week.

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Posted on Monday, October 27, 2014 @ 10:23 AM • Post Link Share: 
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  New Single-Family Home Sales Rose 0.2% in September
Posted Under: Data Watch • Home Sales • Housing

 
Implications: Looks like we're getting a thaw in mortgage lending. New single-family home sales rose 0.2% in September, coming in 17% higher than a year ago and at the highest level in more than six years. This comes on the heels of Tuesday's report, which showed a solid gain in financed existing home sales (as opposed to all-cash deals). Nonetheless, new home sales still remain at depressed levels relative to where they should be by now in the recovery and we believe there are a few key reasons for this. First, the homeownership rate remains depressed as a larger share of the population is renting. Second, buyers have shifted slightly from single-family homes, which are counted in the new home sales data, to multi-family homes (think condos in cities), which are not counted in the report. Third, although we may be seeing a thaw, financing is still more difficult than it has been in the past. The inventory of new homes rose 3,000 in September, but still remains very low as the chart to the right shows, and most of the inventory gains are for homes not started, instead of homes completed. As a result, homebuilders still have plenty of room to increase both construction and inventories. Although the median sales price for a new home was 4% lower than a year ago, the drop is due to the “mix” of home sales in that particular month. Sales of homes under $150,000 made up 13% of sales in September, up from 6% a year ago, another sign of loosening mortgage credit. In other recent home price news, the FHFA index, which measures prices for all homes financed with conforming mortgages, including those not for sale, increased 0.5% in August and is up 4.8% versus a year ago. For comparison, in the year ending in August 2013, the index was up 8.4%. In other words, home prices are still rising but at a slower rate. We expect this trend to continue, with further gains in the year ahead, but more like 3% rather than the faster gains earlier in the housing recovery. In other recent news, new claims for jobless benefits increased 17,000 last week to 283,000. The four-week moving average fell to 281,000, the lowest since May 2000. Continuing claims dropped 38,000 to 2.35 million. It’s still early, but plugging these figures into our models suggests payrolls growth of about 250,000 in October, another solid month.
 
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Posted on Friday, October 24, 2014 @ 10:54 AM • Post Link Share: 
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  The Consumer Price Index Increased 0.1% in September
Posted Under: CPI • Data Watch • Inflation

 
Implications: Consumer prices increased a modest 0.1% in September as the Fed looks to stay on track to finish quantitative easing at the end of next week. Consumer prices are up only 1.7% in the past year and one of the key reasons is America’s booming energy production and, as a result, lower world oil prices. Energy prices declined for a third consecutive month in September and are down 0.6% from a year ago. Given the sharp drop in oil prices in the first half of October, look for more of the same in next month’s report. However, there are sectors where inflation is higher. Food and beverage prices are up at a 3.7% annual rate in the past three months and up 2.9% in the past year. So if you only use the supermarket to gauge inflation, we can understand thinking the headline reports are too low, that “true” inflation is higher. In addition, housing costs are going up. Owners’ equivalent rent, which makes up about ¼ of the overall CPI, rose 0.2% in September, is up 2.7% in the past year, and will be a key source of any acceleration in inflation in the year ahead. The worst news in today’s report was that “real” (inflation-adjusted) average hourly earnings declined 0.2% in September. But these earnings are still up 0.3% from a year ago and workers are also adding to their purchasing power because of more jobs and more hours worked. Plugging today’s CPI data into our models suggests the Fed’s preferred measure of inflation, the PCE deflator, probably rose 0.1% in September. If so, it would be up 1.5% from a year ago, still below the Fed’s target of 2%. We expect this measure to eventually hit and cross the 2% target, but given the bonanza from fracking and horizontal drilling, not until next year.

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Posted on Wednesday, October 22, 2014 @ 10:13 AM • Post Link Share: 
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  Existing Home Sales Rose 2.4% in September
Posted Under: Data Watch • Home Sales • Housing

 
Implications: Existing home sales look like they’re getting some of their mojo back. Sales increased 2.4% in September, have risen in five of the last six months, and are now the highest in a year. Although overall sales are still down 1.7% from that year-ago level, this masks a huge change in the composition of existing home purchases that bodes well for the future. Distressed homes (foreclosures and short sales) now account for only 10% of sales, down from 14% a year ago. All-cash buyers are now 24% of sales versus 33% a year ago. As a result, non-cash sales (where the buyer uses a mortgage loan) are up 11.5% since last September. So, even though tight credit continues to suppress sales, we are seeing early signs of an easing in mortgage credit, which suggests overall sales will climb in the year ahead. Another reason for the tepid recovery so far in existing home sales is a lack of inventory. Inventories are up 6% from a year ago, but down the past two months. In the year ahead, we expect higher home prices to bring more homes on the market, which should help generate additional sales. Either way, whether existing home sales are up or down, it’s important to remember that these data, by themselves, should not change anyone’s impression about the overall economy. Existing home sales contribute almost zero to GDP. Look for better sales in the months ahead. But, unless lenders dramatically loosen standards, the increases in sales will remain tame by historical standards.

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Posted on Tuesday, October 21, 2014 @ 11:40 AM • Post Link Share: 
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  Q3 Real GDP Still Looks Solid
Posted Under: Autos • GDP • Government • Housing • Retail Sales • Trade • Spending
The current recovery started in mid-2009. Since then, real GDP has grown at a 2.2% annual rate (what we have called a Plow Horse Economy). Now, despite a negative first quarter (caused by weather and inventories), the economy is picking up some speed. It’s not a race horse, yet, but we expect 2.5% to 3% real GDP growth, on average, in the year ahead.

The main reason for faster growth is that government spending as a percent of GDP is falling, down to 20.3% of GDP in Fiscal Year 2014, the lowest since 2008, and down substantially from the peak of 24.4% in 2009. Don’t get us wrong, government is still a drag on the economy, just less of one. The Sequester (1/2 of which still stands), an end to extended unemployment benefits, and tapering by the Fed are all signals that the tide may have turned.

Smaller government means a bigger and more vibrant private sector. The unemployment rate fell to 5.9% last month and initial claims for jobless benefits plummeted to 264,000 last week, the lowest since 2000. The labor market is still far from its full potential, but layoffs are few and far between.

Some worry that Ebola is a Black Swan. We aren’t physicians or experts on pandemics. But, Thomas Duncan, the Liberian patient who passed away in Dallas, was admitted into a Dallas hospital on September 28th, twenty-two (22) days ago. Since then, the only domestically-contracted cases of Ebola were two nurses who had immediate medical contact with Mr. Duncan. Not his family, not those who rode on the plane with him, not anyone else who he met while in the US.

It’s the fundamentals that we think we are qualified to speak on and next week we get the initial government report on real GDP in the third quarter. After a 4.6% growth rate in Q2, we expect real GDP to rise at a 2.9% annual growth rate in Q3.

Below is our “add-em-up” forecast for Q3 real GDP.

Consumption: Auto sales increased at a 6% annual rate in Q3 and “real” (inflation-adjusted) retail sales outside the auto sector grew at a 2% rate. Services make up about 2/3 of personal consumption and those appear to be up at about a 1% rate. As a result, it looks like real personal consumption of goods and services combined, grew at a 1.9% annual rate in Q3, contributing 1.3 points to the real GDP growth rate (1.9 times the consumption share of GDP, which is 68%, equals 1.3).

Business Investment: Business equipment investment looks like it grew 12% at an annual rate in Q3. Commercial construction looks like it grew at a healthy 3.4% rate. Factoring in R&D suggests overall business investment grew at a 7% rate, which should add 0.9 points to the real GDP growth rate (7.2 times the 13% business investment share of GDP equals 0.9).

Home Building: A 6% annualized gain in home building in Q3 will add about 0.2 points to real GDP (6 times the home building share of GDP, which is 3%, equals 0.2).

Government: Public construction projects, which had been slowed by the weather in Q1 and rebounded sharply in Q2, continued to increase in Q3. In addition, military spending grew at its fastest pace since 2008 during the third quarter. As a result, it looks like real government purchases grew at a 1.6% annual rate in Q3, which should add 0.3 percentage points to real GDP growth (1.6 times the government purchase share of GDP, which is 18%, equals 0.3).

Trade: At this point, the government only has trade data through August, but what it does have looks very good for US GDP. The “real” trade deficit in goods has gotten smaller in Q3. As a result, we’re forecasting that net exports add 1.0 points to the real GDP growth rate.

Inventories: After a weather-related lull in Q1, companies built inventories at a very rapid pace in Q2, correctly anticipating faster economic growth ahead. Now companies are still building inventories, but not at quite the same rapid pace. As a result, it looks like inventories will subtract 0.8 points from the real GDP growth rate in Q3.

Earlier this year some analysts saw the drop in Q1 real GDP as a sign that the US recovery was done. Instead, we told you to get ready for a rebound in Q2. That’s exactly what we got. One day, the expansion will come to an end, but we don’t see this anytime soon. Even with tapering, monetary policy is still loose, and government is shrinking relative to GDP, giving the private sector more room to grow. Get ready for more respectable growth ahead.

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Posted on Monday, October 20, 2014 @ 10:10 AM • Post Link Share: 
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  Housing Starts Rose 6.3% in September
Posted Under: Data Watch • Home Starts • Housing

 
Implications: Home building has been very volatile over the past few months but the underlying trend remains upward and we expect that to continue. Housing starts jumped 20.8% in July, then dropped 12.8% in August, and now rebounded 6.3% in September. Some look at this volatility as weakness. We don’t. The 12-month moving average is now at the highest level since September 2008. The total number of homes under construction, (started, but not yet finished) increased 0.4% in September and are up 19.5% versus a year ago. No wonder residential construction jobs are up 129,000 in the past year. Multi-family construction is taking the clear lead in the housing recovery. Single-family starts have been in a tight range for the past two years, while the trend in multi-family units has been up steeply. In the past year, 36% of all housing starts have been for multi-unit buildings, the most since the mid-1980s, when the last wave of Baby Boomers was leaving college. From a direct GDP perspective, the construction of multi-family homes adds less, per unit, to the economy than single-family homes. However, home building is still a positive for real GDP growth and we expect that trend to continue. Based on population growth and “scrappage,” housing starts will rise to about 1.5 million units per year over the next couple of years.

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Posted on Friday, October 17, 2014 @ 10:49 AM • Post Link Share: 
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  Industrial Production Increased 1.0% in September
Posted Under: Data Watch • Industrial Production - Cap Utilization

 
Implications: Despite recent turmoil in the equity markets, lots of good news on the economy this morning. Hold off on industrial production for a moment. Initial claims for unemployment insurance dropped 23,000 last week to 264,000, the lowest level since 2000. Companies might not be hiring like they would be with a better set of government policies and faster economic growth, but it looks like they’ve carefully hired the workers they want and are not letting go. Continuing claims increased 7,000 to 2.39 million. Plugging these figures into our payroll models suggests an October gain of about 255,000, another solid month. Now back to the factory sector, where industrial production soared 1% in September, easily beating consensus expectations. About half of the gain was due to strength at utilities and mines, which are very volatile from month to month, but manufacturing output grew 0.5% despite a 1.4% drop in the auto sector. One measure of the underlying trend is the non-auto manufacturing sector, which climbed 0.6% in September, has not dropped in any month since January (remember the brutal winter weather?), and is up 3.5% from a year ago. We expect continued growth in the industrial sector. The housing recovery is still young and both businesses and consumers are in a financial position to ramp up investment and the consumption of big-ticket items, like appliances. Capacity utilization rose to 79.3% in September, which is higher than the average of 78.7% over the past twenty years. Further gains in production in the year ahead will push capacity use higher, which means companies will have an increasing incentive to build out plants and equipment. In other manufacturing news this morning, the Philly Fed Index, which measures factory sentiment in that region, stood at a still solid 20.7 in October versus 22.5 in September. The only blemish on today’s economic news was the NAHB index, which measures sentiment among home builders. The index fell to 54 in October, reversing last month’s surge to 59. However, the drop this month simply brought the index back down to where it was, on average in July and August.

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Posted on Thursday, October 16, 2014 @ 12:07 PM • Post Link Share: 
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  Retail Sales Declined 0.3% in September
Posted Under: Data Watch • Retail Sales

 
Implications: After a very solid report out of the retail sector in August, consumers took a breather. Retail sales fell 0.3% in September, led by a decline in the very volatile auto sector which was expected. But even outside of the auto sector, retail sales were down 0.2%. Gas station sales were a large culprit, falling 0.8% in September as oil prices continue to drop. Prices at the pump on a national average are now down 4.5% from a year ago. The widespread use of fracking and horizontal drilling is making this possible, which means consumers can take the money they save on filling their tanks and spend it on other things. It’s important to remember that even in the best years retail sales still fall in 3 months out of the year, so the decline in September, especially coming on top of the very strong August report, is not something to worry about. Overall retail sales still remain up a very healthy 4.3% from a year ago. “Core” sales, which exclude autos, building materials and gas, were unchanged in September and were up at a 4.3% annual rate in Q3 versus the Q2 average. These sales are a key input into GDP calculations and once we include other spending (on services and durables), our expectation is that “real” (inflation-adjusted) consumer spending, goods and services combined, grew at a 2% annual rate in Q3. We expect consumer spending to accelerate in the year ahead, as lower unemployment means an acceleration in income gains at the same time that consumer debt service is hovering near multiple-decade lows. In other news this morning, the Empire State index, a measure of manufacturing sentiment in New York, declined to +6.2 in October versus +27.5 in September.

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Posted on Wednesday, October 15, 2014 @ 12:23 PM • Post Link Share: 
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These posts were prepared by First Trust Advisors L. P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
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