Now past the halfway point of 2021, have we breached peak economic growth for the cycle?
Fueled by extraordinary fiscal and monetary policy support, personal spending has been strong in 2021, and consumer balance sheets appear well positioned to maintain recent momentum
The market perceived hawkish signals from the Fed at the June FOMC meeting
We are past the halfway point of 2021, and the year has been anything but a flat road for the U.S. economy and broad fixed income. Regarding the latter, the Bloomberg Barclays US Aggregate Index generated a -1.6% return through the first two quarters, with higher Q1 yields overwhelming the positive impact of tighter spreads throughout much of the period. Bond yields traded in a tighter range for much of Q2, and with spreads continuing to firm amid a heavy Fed presence, performance was generally better. What lies ahead for the second half of 2021? No one knows the answer to that question with certainty, but we can make some general observations. For the U.S. economy, growth is expected to have peaked in the most recent quarter, with many economists calling for a double-digit GDP gain (annualized) before slowing toward longer-term averages over time (see Exhibit 1). No additional fiscal stimulus packages are expected, and the current infrastructure spending plans have been largely priced into financial markets. The Fed is finally “talking about talking about” tapering asset purchases, and the updated Summary and Economic Projections (SEP) from the June FOMC meeting showed a hawkish shift in participant forecasts for the first rate hike. The economy still appears to have strong momentum, and the bigger question at this point for economists and market participants alike is whether permanent, above-target inflation is taking hold.
Consumers Well Positioned
Two of the big drivers of consumer inflation in recent months have been airfare and lodging, as we move further away from peak Covid worries and Americans unleash an abundance of pent-up demand. Summer travel plans are funded by consumer balance sheets that are as healthy as they have been in many years according to Fed data. Using the most recent household finance report for Q1, the Fed shows that household assets rose another $5 trillion to more than $150 trillion in aggregate, while household liabilities rose just $200 billion over the quarter. Not surprisingly, most of the asset gains came from real estate ($900 billion) and equities ($2.4 trillion), which increase consumer wealth but are not necessarily a source of significant future consumption, a lesson learned from the financial crisis.
However, a deeper look at more liquid asset categories within the report provides a more promising picture of consumer spending power going forward. The aggregate of currency, bank deposits, and money market fund shares surged by $2.7 trillion in 2020, roughly five times the average annual increase of the prior decade, and these categories rose by another $1 trillion in Q1 2021 alone. While multiple rounds of fiscal stimulus have fueled these increases in the Covid era, various restrictions during much of 2020 and early 2021 constrained consumption and allowed liquid assets to grow at an accelerated rate. This dynamic has been acknowledged by Fed Chair Powell and his colleagues as one of the main drivers of near-term (and transitory) inflation pressures. Once these funds are spent, a more “normal” pace of consumption would presumably return, barring a notable and prolonged increase in personal income. The latter is what many economists consider the prerequisite for more permanent inflation pressures.
A Hawkish Shift?
The June 16 FOMC meeting was highly anticipated in financial markets given the big upside surprises from the April and May inflation reports. This meeting included an updated SEP, which markets tend to (over)react most to, particularly the participant forecasts for the fed funds rate (the “dots”). Regarding the latter, the median participant forecast shifted from no rate hikes through 2023 to 50 bps of rate hikes by year-end 2023. Additionally, the number of participants expecting a 2022 rate hike rose from 4 to 7 (median still shows no rate hike). Additionally, Powell acknowledged that there was a discussion about the path of asset purchases, noting that this was the “talking about talking about meeting” in reference to his previous press conference quip.
Unsurprisingly, the markets perceived the June meeting as a hawkish response to higher-than-expected inflation readings. Powell attempted to pour cold water on the upward shift in the median dot path during the post-meeting press conference, as well as his subsequent testimony before Congress the next week, saying that “the dots are not a great forecaster of future rate moves.” However, if we see more inflation surprises in the coming months, particularly signs of non-transitory pressures (e.g., wage inflation), the market will likely price a higher likelihood of a 2022 rate hike, which would be presumably push intermediate Treasury yields higher and perhaps push long-end yields lower. Regarding the tapering of asset purchases, the general market consensus seems to still be that it would begin late this year or early 2022, with a chance the announcement could be moved up to September if warranted. The last tapering program took approximately 10 months to complete.
A mild surprise at the June FOMC meeting was the Fed’s decision to raise its administered rates by 5 bps. The reverse repo rate was increased to 0.05%, and the interest on excess reserves (IOER) rate was increased to 15 bps. This is not considered a change in monetary policy but was instead meant to help keep the effective funds rate from moving toward zero amid the flood of cash in the money markets. On that note, the Fed announced earlier in the month that, effective July 29, they will no longer refer to IOER or interest on required reserves (IORR). From that date forward, only the interest on reserve balances (IORB) rate will be officially referenced, and it removes any doubt that the Fed may choose to only pay interest on required reserves at some point in the future.
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