Healthy GDP Report Could Put Nail in Economic Coffin for the Fed – Published in Noozhawk on Monday, October 27, 2014

The Commerce Department will release the first report for third-quarter gross-domestic product this week. Real GDP growth is expected to be 3 percent annualized, following the dramatic jump to 4.6 percent growth for the second quarter.

A healthy GDP report on Wednesday could give consumers — who have been reluctant to spend — more confidence in the economy, but may also push the Fed to begin raising interest rates sooner rather than later.

We began 2014 with a hangover, after exceptionally cold weather was blamed for weak economic activity. The U.S. economy contracted by 2.1 percent annualized in the first quarter after a strong 2013 fourth-quarter performance. Although we could see a further revision to the second quarter’s stellar growth result, the bounce back in the second quarter set the stage for good follow-through for the economy, with most economists expecting 3 percent growth in both the third and fourth quarters.

Assuming economists are correct and this week’s GDP report is strong, the implications could still be negative, at least for financial markets. A strong GDP report will certainly place increasing pressure on the Fed to end its economic stimulus activities (QE3) this week, as well as begin raising interest rates early next year — sooner than currently expected.

Another key Fed action that few are watching for, but that is critical to the economy and financial markets, is the reinvestment plan for maturing bonds in the Fed’s massive $3 trillion-plus balance sheet. Through QE3, the Fed has been buying bonds. As these bonds mature, the Fed has been reinvesting the proceeds into new bonds to maintain the size of its balance sheet, to keep the cash actively deployed into the economy.

Once the Fed discontinues buying bonds with new money, it will have to decide when to discontinue reinvesting proceeds from maturing bonds. Through this process, cash will be siphoned off from the economy, further removing stimulus.

This week we will receive multiple economic reports, starting with durable goods and consumer confidence on Tuesday, followed by GDP on Wednesday, the employment cost index on Thursday, and, on Friday, personal incomes, consumer spending, thecore personal consumption expenditures price index and consumer sentiment.

In addition, the most recent jobs report showed 248,000 jobs added in September, and both July and August jobs results were revised higher. In the past year, the economy has added 2.64 million jobs, the strongest year-over-year growth in jobs since 2006.

But one curious feature of the current economy is the lack of consumer spending growth to mirror jobs growth. One explanation could be that the quality of the jobs is not strong, meaning that people who are getting jobs are under-employed — getting jobs that do not pay what they should be earning given their skill set, education, etc. This explanation is consistent with the lack of wage growth we have seen in the data; companies are not increasing pay, even though they should have to at this stage of the economic recovery, since demand for skilled workers is higher.

This week will be interesting from a financial markets standpoint since we have seen a sharp bounce in stocks following the 9 percent correction in the Standard & Poor’s 500 that occurred over the previous few weeks. The S&P 500, which bottomed at 1,820, has rebounded to 1,965, or by 145 points/8 percent, since Oct. 15. From a technical analysis standpoint, that index is sitting just below its 50-day moving average after pushing up through its 200-day moving average.

The economic data, and the Fed’s decision on stimulus, should drive stock market performance this week.

Bonds have also been volatile of late, with the 10-year treasury pushing down below 2 percent briefly before rebounding (prices falling) to yield 2.27 percent by the end of last week. With rates still at very low levels from a historical perspective, the Fed has plenty of room for rates to rise before they become a significant detriment to economic growth. However, rising rates — given the expensive valuations for stocks, and the large spreads for bonds other than treasuries (corporates, high-yield, etc.) — leave these markets highly vulnerable to any upshift in rates.

The Fed will have to balance the direct impact of raising rates, which should not be all that significant until rates rise considerably from current levels, and the indirect (and very significant) impact of sizable corrections in financial markets that are very likely to occur once the Fed signals rate increases are imminent.

This week’s economic reports, and in particular the GDP report, will certainly influence the Fed’s decision-making process, and should give investors some guidance with regard to future Fed policy decisions.

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