Bond Markets & Research

• Market Update
• Newsletter
• Research
• Resources
• Treasury Yield Curve

Economic Update

Written by Jane Caron, CFA, Chief Economic Strategist

Investor sentiment did an about-face in the second quarter. In April, 10-year Treasury yields increased to near 4% and the Dow rose above 11,000 as the self-reinforcing nature of the recovery was widely touted and corporate earnings beat expectations again. Economists, meanwhile, were busy debating when the Fed would remove the "extended period" language from the FOMC statement. By comparison, at the end of June, 10-year Treasury yields were under 3% and the Dow was below 10,000 as investors began to fear a sharp deceleration in economic activity or even a double dip.

What happened? Was the Greek crisis a flap of a butterfly's wings?

In some ways this old metaphor, "Does the flap of a butterfly's wings in Brazil set off a tornado in Texas?" applies: the Greek crisis occurred at a time when investors were sitting on large portfolio returns, and they reacted to uncertainty by reducing risk and realizing gains—an event that became self-reinforcing. Weakness in the markets spilled over to the real economy where the impact of lower wealth and increased uncertainty more than offset the benefit of lower market interest rates.

As a result, we have lowered our real GDP forecast to 3.25% from 3.5%, and believe the risks are still weighted to the downside. We are leaving our 2011 real GDP forecast unchanged at 3%, but we should warn readers that there is a fair amount of ambiguity around this forecast because of unclear fiscal and regulatory policies and the risk that fragile confidence could buckle under increased pressure from economic uncertainty. Still, should subsequent revisions become necessary, we highly doubt that our GDP forecasts will end up below 3% for 2010 and 2% for 2011.

Our GDP forecasts already factor in many of the fears du jour such as severe state and local budget constraints, tightening federal fiscal policy, weak nonresidential real estate spending, a declining lift from inventory restocking, and an expected slowdown in export growth. Thus, we do not believe that these particular headwinds will ground the economy. We are concerned, though, that increased hype in the media about an impending double dip will further weigh on animal spirits, which have already been damaged by tighter financial conditions.

We are carefully monitoring the labor market because it is the cornerstone of this recovery. We are disappointed that the labor market lost strength as the second quarter progressed, but we are still heartened by the level of improvement. The strong advances in private payrolls in March and April were accompanied by healthy gains in the average workweek and average hourly earnings, and this combination led to very strong gains in labor income. In May, private payroll growth was disappointing, but gains in the workweek and hourly earnings were sufficient to provide another strong lift to personal income. June employment data were a disappointment, though, and point to weak labor income for the month.

We are inclined to believe that weakness in June will give way to strength in coming months, so we are maintaining our 1.5% nonfarm payroll annual growth forecast. During the second half of the year, we expect monthly payroll gains to be near 200,000 on average. Such gains should generate a sufficient tailwind to plow through the headwinds listed above. The unemployment rate will probably remain high despite the increase in hiring because labor force growth should also accelerate. We look for a roughly 9.5% unemployment rate at the end of this year and 8.5% at the end of next year.

Politicians remain highly concerned about the sorry state of the labor market, and we expect Congress will ultimately provide more assistance even if extended unemployment benefits are not approved by the Senate in the near term. We are impressed, though, by newfound fiscal rectitude by many Congressmen. We think it would be a mistake to tighten fiscal policy too aggressively at this point in the cycle, but we would heartedly welcome reform efforts aimed at tackling our longer-term fiscal problems. Indeed, fiscal austerity without reform would be a huge disappointment.

Public authorities appear to be aware of the risks facing the economy, and they will most likely renew efforts to support the economy if it stumbles. The Fed will probably be reluctant to re-engage in quantitative easing by purchasing more long-term bonds, but we think fiscal policy is the better tool for the job anyway. At this point, fiscal policy is partially constrained by large budget deficits, but Treasury investors remain willing to supply capital at very low rates so there is still time on the clock. To keep the clock from running out, we think it behooves Washington to demonstrate a willingness and ability to address our long-term structural budget problem at the same time that they keep the cushions adequately plumped under the economy's rump.