U.S. Economy Facing Mounting Risks

by: RadaEcoWatch

Summary

The Fed's decision to maintain monetary policy unchanged at the end of the June 15 meeting was widely expected by economists and investors.

Despite the data published over the recent weeks indicated a solid growth rate of the economy in the short term, the medium-long term perspectives of the US economy are worsening.

Yield curve flattening, declining corporate profits and the downward trend of Fed’s labor market condition index are a negative indication for the economy going forward.

Without a turnaround - or a stabilization - of these indices, the U.S. economy could flirt with recession in late 2016 /early 2017.

The Fed's decision to maintain monetary policy unchanged at the end of the June 15 meeting was widely expected by economists and investors. The weak labor market report in May and the concerns related to the UK referendum on leaving or remaining in the European Union reduced to zero the possibilities of a rate hike.

The new projections of the Fed policymakers on Fed Fund rates in the period 2016-2018 were surprising. In line with March expectations, the consensus estimate inside the Fed was of two 25 basis point increases in Fed Funds rates in 2016. However, six Fed officials projected only 1 rate hike in the current year. The Fed Fund consensus estimate for the end of 2017 has been revised downward from 2% to 1.65% and for 2018 from 3% to 2.375%. The Fed Fund policymakers also revised down the estimate of long-run equilibrium rate to 3.15%.

Finally, the Fed members have also revised down their projections on GDP growth in 2016 from 2.2% to 2%, despite the data published over the recent weeks indicated a solid growth rate of the economy in the short term. The only exception was the May labor market report.

For example, in May retail sales rose 0.5% MoM and 0.3% MoM ex-auto, exceeding consensus estimates. Housing market data were also positive, with housing starts at the highest since 2007 and the NAHB builders' confidence index at the highest since January and at a value in line with a positive trend in the coming months. Industrial production data have been volatile in Q2, but the unexpected increase of the ISM manufacturing index in May anticipated a positive trend during the summer. According to Atlanta Fed GDPnow forecast model, GDP could expand by 2.8% in Q2, a solid acceleration from 0.8% in Q1.

However, in our view, the medium-long term perspectives of the US economy are worsening.

The first negative indication comes from the yield curve trend. The decline of the ten-year government bond yield from 2.2% at the beginning of the year to 1.57% lowered the 10y-3m spread from 200bp on January 4th to 130bp. As we indicated in the article "The U.S. Yield Curve Sends Warning On The Economy And On The Equity Market", the flattening of the yield curve is historically a negative signal for economic activity over the next 12 months. The chance to see a recession over the next 12 months on the basis of the Cleveland Fed model rose from 7.3% in April to 8.3% in May.

Another worrisome sign is the decline of corporate profits. Corporate profit after tax with inventory valuation adjustments fell in Q1 by 5.7% YoY, the third consecutive quarterly decline. This could have a negative impact on investment in the coming quarters, reducing GDP growth.

Finally the downward trend of Fed's labor market condition index is a further indication that economic growth could weaken in late-2016/early 2017.

Despite not signaling a recession yet, all these indicators point to a weaker economy in late 2016 /early 2017. In our view, the recent downward trend of these indices point to a weaker economy in the months ahead, lowering the possibilities that the Fed could raise rates in H2 '16. Indeed, we think that, without a turnaround or a stabilization of these indicators, the risks of a recession of US economy will increase in the next few months.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.