Leader Quarter in Review
The quarter began the same way that 2014 ended – with oil prices and Treasury yields dropping and credit spreads increasing. Major surprises from central banks across the globe shocked financial markets and reversed the “risk off” trade although Treasury yields continued lower. Easy monetary policy from central banks around the world resulted in the U.S. Dollar surging 9% as the Fed is poised to raise rates this year. The European Central Bank announcing a €1.1 trillion purchase program, the Bank of Canada cutting interest rates, and the People’s Bank of China cutting the reserve requirement are just a handful of the moves made by central bankers around the world during the quarter as they compete to devalue their currency and remain competitive.
The 5-year part of the Treasury curve has been the lynchpin in terms of the market’s assessment of the Fed’s first interest rate hike, falling 24 bps during the quarter as investors have pushed out the consensus lift-off date. MBS, Investment Grade Credit and High Yield spreads are all lower for the quarter, however, the yield advantage from corporate bonds has led those sectors to outperform (see performance table). Within credit, energy has severely underperformed the rest of the credit market over the past year (see chart 1).
In the Fed’s latest post-FOMC meeting statement, they removed the "patient" language, opening the possibility for a June increase of the Federal Funds Rate. At the same time, they took down their forward expectation of the Fed Funds Rate implying that the pace of interest rate hikes would be slower than previous cycles. So while Fed officials have indicated a June interest rate hike is on the table, recent data has pushed the consensus hike date out to September.
It is no secret that U.S. economic data was weaker in Q1 than Q4 2014 as a bevy of factors caused a slowdown – harsh winter weather, a stronger US Dollar and the Los Angeles port shut down. The Atlanta Fed real-time estimate of Q1 GDP now stands at 0.1% having declined all quarter (see chart 2). These factors were readily apparent in the weakening of ISM Manufacturing PMI from 55.1 in December to 51.5 in March and the shock 126,000 March jobs report. Although lower oil prices were encouraging for the consumer, it did not translate into spending as retail sales are down 0.14% through February.
Also pushing the consensus “lift-off” date out further has been moderating Core inflation measures attributable to the drop in oil prices. While not directly included in the figures, lower oil prices have flowed through to other goods prices. Indeed, it is goods prices that have pushed core inflation down as goods inflation has dropped sharply (see chart 3, orange line), while service prices have remained robust (blue line). A stabilization in goods prices – either from oil price stabilization throughput or a weaker dollar – should see inflation move higher.
While the March Non-Farm Payrolls report clearly disappointed at 126,000, we estimate that the economy needs to add roughly 130,000 jobs per month to account for population growth. The Fed will most likely look at the March jobs report as an outlier, while an uptick in wage growth and inflation, will be far more important for determining monetary policy. Fed officials have stated the factors that caused the slowdown in Q1 will be temporary and should see a rebound in Q2 and a reversion to trend growth.