Reading Between The Lines Of Today's GDP Report
With investors cheering the government's and Cash for Clunkers' massive contributions to preliminary Q3 GDP, numerous questions remain unanswered, chief among them being why is the dollar now so completely disconnected from any fundamental economic news, and how long can it remain a plaything in the constant shuffle to procure cheap risky assets even when it should get at least a moderate pop on an improving US economy. With the Fed expected to not raise rates for almost two years, the economy will not have an impact on the US currency for a long time, as such putting the country in a position where it may well face hyperinflation as the Fed continues to combat the current deflationary episode with every instrument imaginable.
Ironically, ongoing "good" data which are simply the result of various one-time, presumably non-recurring stimulus and subsidy programs will sooner or later translate into inflation, if pushed long and hard enough. And as broad based deflation is still the primary threat, courtesy of declining wages, even with gas again approaching $3.00/gallon, Obama may have boxed himself into a corner with his numerous TV appearance claiming that the economy has essentially mended. Of course, even first year analysts at investment banks know to exclude one-time benefits/charges from ongoing operations. It is a pity the US president, however, never sat in on the Goldman Sachs analyst class: one imagines the firm owes him at least that much.
Either way, as stimulus and liquidity benefits taper off, with the Fed's inability to buy any more treasuries a key case in point, the economy has rebounded sufficiently high for even some of the most violent bears to throw in the towel. Yet Q4 GDP will see the impact of the stimulus programs falling away (and one hopes at least one regional Fed will support some of this inventory build data that the government is doing all it can to make the population believe is currently occurring). So even as Goldman engineered a perfect bear trap with their surprise revision lower, expect Q4 GDP to provide not only a likely lower adjustment to Q3 economic data, but to be a real miss to the 2.4% consensus reading (regardless of what Goldman does a few minutes before the number's official release). And with a range of GDP expectations from -1.5% from Mizuho to 5.5% for First Trust (good luck boys), it is pretty safe to say that nobody really knows what will happen, except that everyone has grown increasingly optimistic on Q4 GDP over time. What is simply ludicrous is that Q4 GDP now is expected to be higher than what it was expected to be in March of 2008 (2.2%). Gotta love government interventions.
And for those who care to think between the lines, UBS has released a client note which has observations on what, briefly, one can expect out of the US economy. Nothing earthshattering here, but useful to see that someone still is capable of some rational thought out there. Point 3 is particularly notable.
1. Good data could translate into inflation expectations
We acknowledge up front that the Fed does not have a very strong inflation mandate (compared to the ECB) and this is one reason market expectations for FOMC policy rates are relatively subdued at this stage. In addition, the first step for policy 'tightening' will be balance sheet reduction and cessation of liquidity programs, rather than outright rate hikes. However, this does not mean that interest rate expectations can be ignored indefinitely as growth figures pick up. The chart below shows the relationship between inflation expectations, as measured by the 5y5y forward breakeven, and arguably the two most important data points in the US economic calendar: Non-farm payrolls and manufacturing ISM. Both releases have been gaining since Q4 this year and inflation expectations appear to be tracking the trends through Q2 this year before stabilising. At present, the jump in inflation expectations is likely due to a combination of Fed debasement fears or actual a return in trend growth, but the former will become the dominant driver if trend growth does pick up materially, as markets view current Fed policy as incompatible with economic performance. The end result would likely be a shift in the Fed's bias to contain inflation expectations.
2. Good data may steepen the yield curve
The steepening in the US yield curve has attracted a lot of attention in recent days, even though the specific drivers of the move remain unclear. Over the past decade, better growth, especially during a recovery phase of an economic cycle has translated into a steeper yield curve, but this certainly does not spell good news for equity markets either, as the chart below clearly shows an inverse correlation between the two. This relationship appears to have broken down during the phase of the crisis but it is premature to suggest the status quo can be maintained indefinitely. The rebound in the S&P has largely been liquidity driven rather than growth-driven, and once markets will need to revert back to fundamentals, a steep yield curve would hinder advance in equities, especially as it implies steeper
borrowing costs across the board. Add on the fact that the US Treasury is expected to drastically increase the amount of supply due to stimulus efforts, and anecdotal evidence pointing to reserve manager purchases reverting towards maturities, steepening pressure will unlikely subside anytime soon.
3. Remember, policy is about liquidity, not rates
When the FOMC sets policy, fundamental economic developments will still determine where policy is headed, but at this stage, policy is balance sheet policy rather than the Fed's target rate. As the chart below shows, trends in the Fed's balance sheet are playing a role in where markets are headed to globally, and going back one step, the US' growth patterns up ahead will determine in which direction the Fed's liquidity policy will evolve. At this stage the risks are balanced. The size of the Treasury purchase programme does not look like being revisited anytime soon, and the Fed's MBS purchases will be somewhat offset by existing programmes expiring, though nominally the balance sheet is still expected to expand. If data over the next few months improves to the extent that the Fed will confirm its balance sheet growth will cease, current correlations suggest markets will also stop rallying, despite data coming through as positive. One could even argue that risk markets' gains have already fully priced in economic growth under Fed stimulus. As such, Q3 and Q4 growth figures will have a significant bearing on where policy globally is heading next year, especially as most central banks will not move ahead of the Fed. If the recovery is sufficient enough for liquidity growth to stop, risk appetite may well correct rather than improve.