Strong Second Quarter Bodes Well For The Fed

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Includes: FXE, UDN, UUP
by: Citylytics

Summary

The US economy gained momentum in the Q2 in line with Fed's expectations.

The strengthening labour market will continue to support personal consumption growth.

Strong growth and improving labor market should be enough to convince the Fed to deliver one more rate hike this year.

Current EUR/USD levels are good opportunity for buying dollars.

The US long-term yields have at least 20-30 basis points growth potential by the year end.

After barely increasing by 1.2% yoy in the Q1, the US economy gained momentum in the Q2 and expanded by 2.6% yoy. Such outcome proves that the Fed was right when pointing out that the Q1 weakness was just a transitory thing.

Chart 1: Real gross domestic product movements

Source: Federal Reserve Bank of St. Louis

A brief look at the categories reveals that growth was mainly driven with 2.8% yoy increase in private consumption (versus 1.9% yoy in the Q1). Furthermore, non-residential investments increased by 5.2% yoy and government spending increased by 0.7% yoy after being in negative territory in the Q1. Weaker dollar and solid global demand also helped growth, with net trade adding 0.2 percentage points to growth.

The data for the past three years were revised slightly and thus showed somewhat stronger growth in 2014 and 2015 while the one reported for 2016 was revised down slightly.

That said, the Q2 growth is largely in line with the Fed's expectations. This means that the Fed will probably keep its economic outlook unchanged at the next meeting in September. According to the Fed's current estimates, the US economy is set to increase by 2.1% this year and 2.1% in 2018. Furthermore, this all means that the Fed will probably once again look through weakness in inflation and reiterate their view that solid growth and improving labor market will at some point boost inflation. Indeed, the strengthening labor market will continue to support spending power and personal consumption growth. All this should be enough to convince the Fed to deliver one more rate hike this year as planned even if the inflation fails to pick-up in the rest of the year.

As I have already argued (The Fed vs. the market: Who is right?) the market is not pricing any more rate hikes this year. The latter can be seen in Fed funds futures pricing that currently imply that the Fed fund rate will be at the upper bound of the current target range by the end of this year. Therefore, I would use the current EUR/USD levels for buying dollars. Furthermore, US long-term yields have at least 20-30 basis points growth potential by the year end so it is worth considering shorting the long-end US Treasuries.

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.

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