Thursday 30 November 2017

US economy growing 5.5% vs 1.25% Fed funds?

The BEA Q3 GDP release today had the US economy growing 5.5% in USD/ nominal terms, albeit with non-financial profits going sideways since 2013. 

Only in Janet Yellen's mind could there be uncertainty as to whether interest rates should be 1.5% or not. The market has to look for 4 hikes next year, which would take Fed funds to 2.25-2.5%. 

Question is what the 10 year does. With balance sheet reduction I think that should put selling presure on it, however if people sell HY and buy bonds that would offset it. 

So far it looks like the curve has been trying to flatten. If the spread went to 50bps, it would imply a 10 year in a years time at 2.75-3%. With recession/ inflation scares that might give a trading range of 2.5-3.5%. 

Versus perhaps 6% nominal GDP growth its still massively negative in real terms however. So the quesiton would be whether the Fed can hike enough to curtail a wage inflation cycle and risk a recession, or if they stay permanently behind the curve. 

The financial economy is likely to act like its a recession far earlier than the real economy, aggregate asset prices have to fall as QE sees a fall in liquidity and rate hikes push up discount rates.

This Fed being trapped behind the curve vs triggering a real economy recession debte doesnt seem to be a focal point right now. Kashkari yesterday even said they should be able to tolerate 5 years of inflation above target given they have had 5 years below. The problem would be is inflation starts to push to 3 or 3.5% on full employment,  but we definitely need more wage growth in the areas of strength for that to happen and its unlikely to be an issue in the next six months. 

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