The ALM First Quarterly Economic Outlook provides financial institution management concise and relevant economic data that has both a direct and indirect impact on the institution’s financial well-being. Clients often find the information useful in planning balance-sheet strategic action plans for the upcoming quarter.
First Quarter Review
Financial Markets
U.S. stock prices extended their rally during the first quarter, after battling back from a steep selloff in February amid continued global economic and political uncertainty. The Dow Jones Industrial Average gained 4.1 percent or 428.58 points during the first quarter, to end the quarter at 10,856.63. That marked the Dow's fourth consecutive quarterly gain and the best first-quarter performance since 1999. The broad Standard & Poor's 500-stock index rose 4.9 percent to 1,169.43, but still remains 25 percent below its all-time high posted in October 2007. The best-performing stocks have tended to be the most volatile and generally lower-quality names. The Russell 2000 index of small-company stocks posted the largest gain among the big benchmarks with an 8.5 percent increase. Financial stocks also rallied despite the likelihood of stepped-up regulation and lower future profits.
Throughout the quarter, stock investors got a taste of the kind of volatility that could be in store for some time to come as governments and central banks continue to work through the aftermath of the 2008 financial crisis. Markets were rattled as China took the first steps to reverse its economic-stimulus programs, Europe struggled with huge budget deficits and an unsettled political climate dominated U.S. headlines with the passage of the healthcare bill and upcoming midterm elections.
Despite fears of rising interest rates and an uncertain economic outlook, credit markets performed very well. Abundant new issuance and investor appetite pushed bond prices higher. At the start of this year, rising prices and increasingly robust corporate bond issuance carried over from a protracted 2009 rally. In late January, worries about the credit-worthiness of Greece and other European nations combined with concerns about U.S. government borrowing and proposed new bank regulations to weigh heavily on corporate bonds.
Treasury security issuance totaled $601 billion in the first quarter of 2010, compared with $454 billion in the first quarter of 2009. Investors eagerly acquired most Treasury offerings. That helped push up Treasury yields, which move inversely to prices. The 10-year Treasury yield stood at 3.84 percent at the end of the quarter, compared with 3.83 percent at the end of 2009. It dipped as low as 3.55 percent in early February.
Longer-maturity bond yields have risen in recent weeks and the gap between long- and short-term rates is much higher than normal. Potential explanations range from the fact that the economy is returning to normal to the idea that investors are losing their appetite for government debt.
Fannie Mae and Freddie Mac both announced in February that they would buy out loans that are 120-day or greater from their securitized products. Freddie Mac did theirs all at once while Fannie Mae buyouts will occur over a few months. The moves stemmed from an accounting change that made it more cost-effective for the GSEs to accelerate purchases of delinquent loans and hold them in their own investment portfolios. The effect of this on investors was a higher than expected level of prepayments and additional funds available for fixed income purchases.
Monetary Policy
The January FOMC meeting was mostly more of the same, as the Committee’s economic assessment remained favorable. The Committee stated, “…economic activity continued to strengthen and that the deterioration in the labor market was abating.” There was a dissenting vote from Thomas Hoenig, “who believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the Federal funds rate for an extended period was no longer warranted.”
In February the Fed announced that it would raise the discount rate by 25 basis points to 0.75 percent. Re-establishing a “normal” spread between the discount rate and the Fed funds rate is simply the final step in closing down the liquidity facilities, yet it seemed to take the markets by surprise. This was despite the fact that in the press announcement, the Fed stressed that its action was just a “normalization” of its lending facilities and did “not signal any change in the outlook for the economy or monetary policy.” Normalizing the spread between the discount rate and the funds rate is merely the last in a series of steps designed to remove emergency liquidity facilities that were put in place in 2008 and 2009.
In March the FOMC left rates unchanged once again and continued to pledge “exceptionally low rates” for an “extended period.” There were a handful of changes in the statement, but most were either an acknowledgement of small shifts in the data or changes already announced and already implemented. The minutes of the meeting indicated that a number of FOMC members noted that the Committee’s expectation for policy changes was contingent upon the progress of the economy rather than any passage of time.
There were two slightly more significant changes. First, the Fed dropped its assertion that “employers remain reluctant to add to payrolls.” Second, the Fed dropped its option to reopen liquidity facilities if need be, which is a further indication they intend to abide by their decision to close the TALF on June 30 for mortgage-backed loans and on March 31 for all other loans.
Finally, there was a significant change in Thomas Hoenig’s dissent. He said the FOMC may contribute to “financial imbalances” and could increase “risks to longer-run macro-economic and financial stability” if the extended period pledge remains. This is a remarkable, unprecedented criticism of the Committee by an FOMC member in an FOMC statement, but it’s not likely to accomplish much.
The Fed officially ended its $1.25 trillion mortgage-backed (MBS) purchase program on March 31st. The decline in rates and in spreads for MBS, ABS, and CMBS due to this and other programs such as TALF have been dramatic. The market will be paying close attention to any spread widening related to the Fed’s exit. However there is a great deal of investor demand on the sidelines ready to take advantage of any widening in MBS spreads, not to mention cash flows from the Freddie Mac and Fannie Mae delinquency buyouts that need to be reinvested.
Economic Growth
The final report for fourth quarter GDP showed that growth accelerated by 5.6 percent. Nearly two-thirds of the growth was the result of businesses restocking their warehouses and store shelves, after drawing down inventory during the recession, while consumer spending rose only 1.6 percent. Fiscal stimulus was still a big factor but corporate profits also rebounded, rising 31 percent from year-ago levels.
The initial January jobs report brought a downside surprise as nonfarm payrolls fell 26,000 while the consensus expected a rise of 15,000. On the other hand, the unemployment rate fell to 9.7 percent and has stayed at that level since. The February report turned out better than expected, but still fell 36,000; however, the March report showed positive job growth of 162,000, the largest monthly increase since March 2007. Furthermore, there was a net upward revision to January and February of 62,000.
Almost all of the strength of the March report was in private payrolls, which rose 123,000. Since private employment came in better than expected, it meant census hiring was lower than expected so more government hiring will take place later in the spring. The bottom line is that it confirms the economic recovery has spilled into the labor market and that the recovery should be sustainable.
While we believe this is the start of a sustained rebound in employment, which should carry the economy forward as fiscal stimulus begins to fade next year, it by no means indicates that we are out of the woods. A total of 33 states have depleted their unemployment funds and borrowed more than $38.7 billion to provide a safety net, according to a recent report by the National Employment Law Project. At least four more are on the brink of insolvency.
Housing
The housing market looked like it might have stabilized late last year, only to show further weakness in demand over the past few months. Indeed, if a larger-than-expected number of foreclosures were to further depress real estate activity later this year, it is even possible the Fed could restart its mortgage purchase program. Existing home sales fell 0.6 percent in February, to an annualized pace of 5.02 million units. This is the third consecutive decline in monthly sales of previously owned homes, coming off of a 6.49 million unit pace high in November 2009. Total sales were up in the Midwest and Northeast.
The median price of a previously owned home rose to $165,100 from $164,900 at the start of the year. On an annualized basis, the median price is down a minimal 1.8 percent. Despite the front-loading of sales into the first time home buyers’ tax credit program, and the unfavorable weather, home sales did not suffer as much as they could have. Additionally, while signs of price stability may be a key indicator for potential home buyers to move into the market, it may also signal to many homeowners that now is the time to sell, keeping inventories elevated. It is a delicate balance that will not be resolved in one or two months.
The number of foreclosed homes that banks are trying to sell is on the rise again, suggesting certain U.S. markets will experience further downward pressure on home prices. Mortgage analysts at Barclays Capital estimate banks and mortgage investors held 645,800 foreclosed homes in January, a 4.6 percent increase from the 617,286 held in December. The supply peaked at around 845,000 in November 2008.
With the country braced for four million or more foreclosures this year, the government is still searching for an effective way to stop the rot in housing. Under the Home Affordable Mortgage Program (HAMP), only 170,000 borrowers have received permanent loan modifications, well below the target of 3-4 million. A revamped HAMP was unveiled on March 26th; the question is, will it succeed where the first round failed?
Two policy changes – a new “earned principal forgiveness” initiative in HAMP, and the short refinance program through the FHA – will reduce the downside tail risks to home prices and housing. If implemented effectively, these changes, by strongly encouraging principal write-downs, will help reduce the “shadow inventory” of yet-to-be foreclosed homes and the likelihood of strategic defaults (mortgage-holders choosing to walk away due to negative equity).
Until now the focus has been on lowering mortgage payments as a share of income, mainly through interest-rate reductions and term extensions. New rules put an emphasis on reducing principal (ie, loan balances). Forgiving some of this debt makes it less likely that borrowers will throw away the keys.
The new plan aims to help in four main ways. It offers incentives for loan servicers (which collect payments for investors in mortgage-backed securities) to reduce principal for those owing more than 115 percent of the property’s current value; the write-down will be staged over three years if the borrower keeps up with lower payments. Second, struggling borrowers who have kept up their payments can switch into loans guaranteed by the Federal Housing Administration (FHA), a government agency, as long as their loan is reduced by 10 percent or more. Third, jobless borrowers will get up to six months of payment assistance while they look for work.
The final element is perhaps the most important. The government hopes to remove a blockage in the modification process with a bribe to holders of “second lien” mortgages, such as home-equity loans. These lenders have resisted modification of first mortgages, fearing write-downs of their second liens. The inducement is a payment of between ten and 21 cents on the dollar for balances they cut.
Second Quarter Outlook
Evidence continues to mount that the U.S. economic recovery is proceeding in an almost traditional fashion despite numerous hurdles. While it has lacked a leading sector or a powerful driving force, it is becoming ingrained. Employment has finally begun to grow and hours have started to rise. Despite slow wage gains, we expect these increases will boost “core” wage and salary income needed to sustain both consumer spending and a rising saving rate.
The effects of harsh winter weather on the economy were smaller than originally thought. Levels were healthy in March for domestic and overseas orders and other forward-looking indicators suggest additional momentum for sustainable growth. As inventories get leaner, there is scope for inventory accumulation. With employment and hours now rising, “core” wage and salary income should begin to sustain both gains in consumer spending and a rise in thrift.
The baseline view is that U.S. economic growth in 2010-11 will be moderate but sustainable. Continued improvement in financial conditions in recent months has bolstered chances that economic recovery can transition safely to expansion later this year. A key feature of sustained recoveries is a transition from government income supports to employment-based income growth. We are finally seeing evidence of a modest recovery in the labor market with rising employment, steady upward revisions to payrolls and a widening array of industries increasing headcount.
Private payrolls have increased in each of the past three months and in four of the past five. The upswing since November has been unmistakable. At the same time the average workweek among private workers has been inching higher. Consumer spending has started to accelerate and is beginning to gain the additional support of rising labor income.
Also contributing to the potential for a brighter outlook are the following factors: (1) new foreclosure mitigation proposals could dramatically improve prospects for housing; (2) the Administration appears likely to extend current tax rates for all but upper-income taxpayers; and (3) incoming data have been stronger than expected, supporting our view that a spring snapback from harsh winter weather is underway. The upshot is that the recovery still looks subpar by historical standards, but courtesy of some not-so-traditional key drivers, it is beginning to look more like a traditional cyclical upswing.
The growing conviction that the U.S. economy is on the mend despite weak spots such as housing is providing support for the stock market. For the most part, talk of a “double dip" back into recession has faded as a possibility. However as the second quarter gets under way, stocks will face perhaps their biggest hurdle of the year with the Fed inching forward with its plans to end, and ultimately reverse, its unprecedented easing of credit. Investors seem to be taking Fed officials at their word that they have everything under control. But should the central bank's removal of credit-market supports fail to go smoothly the markets could be vulnerable to another downswing.
The downside of the improving economy is the potential for higher interest rates. Cheap money has helped fuel the rally in riskier investments over the past year. The key question is when will rates rise and how the markets will handle the increase. More problematic for the market could be if the Fed's removal of credit-market supports, such as its end to purchases of mortgage-backed securities, doesn't go well.
While benign inflation and a patient Fed remain important near-term anchors for long-term interest rates, cyclical forces have begun to support higher real rates and a rising floor under bond yields. Cyclical swings in interest rates are also obscuring (at least in the short run) a gradual deterioration in the longer-term outlook due to a worsening public debt burden.
Long-term interest rates are edging upward but further increases are expected to be gradual. In this setting, long-term interest rates have begun to establish a clear upward trend and a rising floor. In recent weeks, ten-year Treasury benchmarks have been flirting with the four percent level. With short-term remaining low, this creates a steeper slope in the yield curve.
What does a very steep yield curve tell us? One possibility is that the economy is heading for a vigorous recovery. Long-term rates are often seen as a forecast of future short-term rates. So under this theory the markets could be predicting that the Federal Reserve will eventually increase rates because the economy has been restored to health.
This time, however, a steep yield curve is hardly stimulating bank lending. Bank credit has contracted over the past 12 months. Big companies are turning away from the banks to the bond market as a result: high-yield bond issuance in March broke the previous monthly record.
A rise in long-term bond yields could indicate a belief that inflation is set to soar. However, inflation is expected to average just 2.4 percent between now and 2028. The most plausible explanation for the steep yield curve is the interaction of monetary and fiscal policy. On the monetary side the Fed is holding short rates at historically low levels in response to the severity of the crisis. On the fiscal side America’s budget deficit has soared to over 10 percent of GDP, leading to heavy debt issuance.
This conundrum leads to formidable tensions in the rate outlook, with uncertainties on both sides of the recent trend. The upside for yields is checked to some extent by the combination of super-low short-term rates and recent hints that already low inflation might be edging down further. This last point has encouraged Fed officials to reaffirm rate guidance suggesting they are in no hurry to abandon their current stance.
The unemployment rate hit 10 percent at the end of 2009, and is likely to remain well in excess of any reasonable estimate of the inflation-neutral rate for some time. If the labor market improves only gradually, then the Fed may decide to delay raising rates. Keep in mind that a few months of positive payroll data will not be enough to get the Fed to start increasing rates, although it may kick-start the process of refining the language in the FOMC statements
Economists estimate that the U.S. will add about 133,000 jobs a month. While that sounds much better than the months of losses we’ve seen, 100,000 new jobs per month are needed just to soak up new entrants to the workforce, so that pace of job creation will do little to reduce the unemployment rate.
About a quarter of the 15 million jobs eliminated since the recession began won’t come back and will ultimately need to be replaced by other types of work in growing industries, according to a recent Wall Street Journal forecasting survey. The situation is even worse for the long-term unemployed. The average length of time a jobless person has been out of work recently reached 31.2 weeks, the longest since the government began keeping records in 1948.
The participation rate has fallen sharply as many workers have given up their job search. However, as the labor market improves this could entice these workers back into the labor pool. This will slow any drop in the unemployment rate as these re-entrants compete with current job seekers. And, with the unemployment rate still elevated the Fed will proceed with caution as it implements its exit strategy.
The government’s efforts to modify mortgages have been fraught with difficulty. It is going to take a significant amount of time to resolve the foreclosure situation.
With the first quarter now behind us, continued improvements in financial and economic conditions have for the most part solidified the chances that the economic recovery is underway and can move into expansion next year. Fed tightening is still several months away, but inflation remains benign and we are finally seeing evidence of a recovery in the labor market, which is key. A premature fiscal tightening is arguably the greatest risk to near-term growth. In response, we would expect the Fed to step in and maintain low interest rates for a longer period of time.
The headline nonfarm employment statistics will be skewed somewhat by government hiring of 2010 census workers. The Fed will be looking for a durable recovery in private sector employment, which is unlikely to begin in earnest until the summer.
On balance, low inflation and a patient Fed are likely to provide important anchors for interest rates in the months ahead. But these forces are expected to give way gradually to traditional cyclical undercurrents and the ongoing but slow-moving effects of a worsening public debt burden.
ALM First Financial Advisors, LLC has prepared this document based on information we have received from a variety of sources. While we believe this information is reliable, we make no representation as to its accuracy or completeness, and are not responsible for any errors or omissions or for the results obtained from the use of such information. Any opinions or estimates expressed herein reflect our judgment at the date hereof and are subject to change.
This report is for informational purposes only. Neither the information nor any opinion expressed is intended as an offer or solicitation for services.
