Is the Economy Building Steam? Treasury Yields Say The Jury Is Still Out

May 5, 2014

Washington (May 5)  The data we collect suggest second quarter economic activity isn’t yet building up the steam to power the economy ahead in the second half of the year. If anything, the current run of released government data read to us more like the release of pent-up demand from winter.  The Treasury market has been lowering real yields, notably at the long end, ever since the Fed officially began to taper in late December. The long end of the real yield curve (10s vs 30s) has also been flattening for an even longer period. Equity market participants, seemingly happy with the notion Yellen continues to add liquidity if the economy falls flat (it would be news if she didn’t), seem to be missing the negative implications of a flatter long-end of the TIPs curve on the equity market (flatter curve usually presages lower market indexes).

In looking through the array of last week’s data in the context of Fed policy aims (ending QE ASAP), average hourly wages were only up 1.9% Y/Y and unchanged from March to April. There are any numbers of reasons why wages aren’t rising in response to falling short-term unemployment rates and rising cost of basic living expenses (rent, gas, and food).  One reason is an employment recovery centered in lower paying jobs – retail and leisure & hospitality, for example. Average hourly wages in retail are 70% of the national average and in leisure it is 58%. The next higher category, nondurable goods production, is 86% of the national average. In the past 12 months, these low-wage jobs have averaged about 30% of the monthly gain in total private sector payrolls. From 2002 to 2007, the average was around 11%.

The slow pace of wage growth is seen more broadly in the March personal income data. The rate of growth for wages and salaries deflated by the cost of food, rent, gas, and utilities has been dropping and is subpar relative to prior recoveries. Real disposable income, to use another measure of income, is only about 8% higher than when the recession ended, about half as good as “normal” – and the worst recovery among the post-war collection of recoveries.

Given the combination of low wage jobs, low real wage growth, and declining labor participation (retirement is helping drive this number lower but less people working, for whatever reason, means less native growth in spending and especially leveraged spending), the road to accelerating overall real GDP growth lies with business spending.

The recent ISM data effectively support the notion of stable but not accelerating industrial activity when we look at the low and trendless level of new orders to inventory in the past several months. There had been, from the beginning of the recovery, a boost from constructing more manufacturing activity. This boost may also now be flattening out. Construction spending is, however, still growing enough to create some decent steady growth in construction employment outside of residential construction jobs – as we saw in the April jobs report. Ultimately, the economy needs more rapid expansion in capex net of depreciation as a percent of GDP. This measure too seems to have lost its acceleration and appears to be settling into a mid-cycle trend path below what the economy achieved in prior recoveries.

Indicators of growth but not acceleration in manufacturing and related activity (capex, for example) returns us to the flattening spread between 10 and 30 year real Treasury yields to the S&P 500. The narrower (flatter) spread and falling level of 30-year real yields may very well be taking its cue from housing and production and indicating less confidence in the economy’s ability to sustain even its current 2.5% real rate of growth if nominal rates rise because the Fed steps away, however gingerly. The impact from higher rates in this scenario is different from when rates rise because of strong credit demands rooted in a perceived higher return on capital (rising real interest rates at the longer end of the curve). This is one reason why most members of the FOMC are talking down rate increases, they do not want forward prices running ahead and slowing the economy before the Fed is ready to raise short-term rates. Think the negative impact of taper-talk on the housing market six months before the Fed officially began to taper.

In sum, evidence at the moment suggests the economy is getting some winter catch-up out of the way. Evidence does not suggest steam being built to send the economy into a higher orbit, call it sustained growth of 3% or higher. Nothing is written in stone and the recent drop in nominal yields could yet flow through to housing and boost activity in that sector. The better more sustainable route for growth is still through increased capex and resulting higher production. Here, indicators suggest growth but little if any acceleration.

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