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Market Turbulence

​​​​​Don't say we didn't warn you

Just three weeks ago we warned that when risk-free rates rise, they do so abruptly, and that investors should not be complacent. At that time the 10-year Treasury yield had risen roughly 50 basis points from its recent low in September. Over the last few weeks it has risen by roughly another 30 basis points. The 10-year yield hit a recent high of 2.89 percent, its highest level in about four years. And the 30-year Treasury yield recently reached about 3.14 percent, its highest level since last March. Here's why:

  1. Expectations for inflation are increasing. We recently noted that inflation had accelerated in the latter half of 2017, particularly in the fourth quarter. And that occurred before any direct impact from the tax legislation which the Treasury market fears could lead to wage and price inflation.
  2. The supply-demand dynamic in the Treasury market is changing. Treasury issuance this year should reach around $1 trillion, roughly double the amount from 2017. Meanwhile, the Federal Reserve, one of the largest purchasers of Treasuries since the recession, has not only ceased purchasing but has begun selling its holdings as well. This means that all other things equal the Treasury will likely have to offer higher yields to investors.
  3. Partly because of the factors noted above, the market is slowly starting to believe that the Fed will hike rates at least three times this year. That marks a reversal from recent years when the market believed that the Fed was crying wolf and being too aggressive in its forecast. Yields usually move together across the yield curve so at some point continued upward pressure on the short end of the curve was going to translate into pressure on the long end.  

Impact of tax cuts not yet felt

As noted above, these changes are occurring before any direct impact from the tax changes. That impact should be felt this quarter.

The Atlanta Fed's GDP Now model currently forecast​s a 5.4 percent 
annualized growth rate for the economy in the first quarter.

Although the model has been overshooting in recent periods, even if it overshoots by 2 percent that would still be a growth rate of 3.4 percent. That would mark the strongest first quarter growth rate since 2006 because the economy has shown notoriously slow growth during the majority of first quarters of the last 11 years. Growth of this caliber this late in the economic cycle risks overheating the economy, producing faster inflation than real economic growth and higher interest rates, which would ironically hasten the end of the expansion. We highlighted this possibility soon after the presidential election in 2016 and it bears close watching in 2018.

Job market still tight​

The economy created 200,000 net new jobs in January, a remarkable result this far into an economic expansion. The unemployment rate was unchanged at 4.1 percent, its lowest level since December 2000. Wages, often considered the weakest feature of the labor market, grew by 2.9 percent on a year-over-year basis in January. That marked the strongest growth rate for wages since 2009 and agreed with what the employment cost index (ECI) for the fourth quarter of 2017 said last week.

Job growth could receive a boost from the tax cut in 2018, 
but the largest concern remains the scarcity of labor to fill open jobs. 

As labor becomes increasingly difficult to find, wage growth should accelerate further which could also put upward pressure on inflation at a time when inflation is set to rebound.

State of the union held implications for the economy

Among the topics discussed during the speech, two key items stand out. The president asked Congress to produce a bill for at least $1.5 trillion in new infrastructure investment. The administration continues to talk about infrastructure with no real plan in place. We remain in favor of infrastructure investment, but funding remains a key problem, particularly after recent tax legislation looks to add significantly to the deficit over the next decade.

The president also discussed immigration, another issue with important ramifications for the economy. Although the administration states that it supports a path to legalization for the “Dreamers” who were brought to the U.S. by their parents as children, any bill likely to pass in the House of Representatives would probably cut legal immigration. The administration has said it supports a bill that could cut legal immigration by an estimated 40 percent.

At a time when the birth rate in the U.S. has fallen below the replacement rate
and the entire net growth of the labor force (vital for economic growth) should come from immigration,
 restrictions on immigration are counterproductive and would likely reduce potential economic output.

Based on the agreement hashed out in late January, immigration was supposed to be addressed before funding for the federal government runs out again on February 8. But it seems unlikely anything substantial will be decided this week and there will be another continuing resolution to keep the government funded.

Yet the longer immigration goes unresolved, the greater the chance that it gets tied to the increase in the debt limit which currently stands at roughly $20 trillion. The Congressional Budget Office (CBO) estimates that the Treasury has until mid-March; if the debt ceiling is not raised by then, the Treasury cannot auction new notes to fund the government. Consequences could include partial government shutdown, suspension of Medicare, Medicaid, and Social Security payments, higher yields on bond prices, and a weaker dollar.

Changing of the guard at the Fed

Chair Janet Yellen oversaw her last Federal Open Market Committee (FOMC) meeting last week with Jerome Powell assuming the role this week. Although the FOMC left rates unchanged, the committee signaled that the next rate hike was likely coming at the meeting in March. The statement produced by the committee indicated that it sees inflation firming and rebounding from the weakness in the first half of 2017. The committee held to their forecast of three rate hikes of 25 basis points each this year, which agrees with our forecast. But the risk to more rate hikes now lies on the upside with stronger acceleration in economic growth, inflation, and wages all simultaneously emerging.

What it means for CRE
In the short run, acceleration in the economy and the labor market supports demand for virtually all commercial real estate property sectors. And the tax legislation contained many facets that will benefit commercial real estate investors. That combination of firm demand and favorable tax treatment should provide support for transaction volumes and pricing. In the medium run, we reiterate our concern that once the upside of the tax cuts becomes part of the economic base and higher interest rates become a more durable feature of the economy, economic growth will slow. 


What else we are watching this week

The equity and bond markets will take center stage as the equity market heads for a 5-percent sell-off while bond yields continue to rise. The ISM non-manufacturing index for January should surprise on the upside, driven by optimism surrounding the outlook for the economy.


Thought of the week

The last correction in the U.S. equity market (measured by the S&P 500 index) of at least 5 percent occurred in late 2015 and early 2016, an unusually long period of time.

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