Bullish on bonds, bullish on the dollar

Harry Colvin, director and senior market strategist at Longview Economics, tells IG’s Victoria Scholar he is bullish on US bonds and the dollar as they discuss the biggest risks to the US economy and markets.

More US growth to come? 

US economic growth beat expectations this week for the last three months of 2017. The final fourth quarter (Q4) gross domestic product (GDP) estimate was revised higher to 2.9% quarter-on-quarter, thanks to the biggest jump in consumer spending for three years, outweighing an increase in imports. However, there are concerns that growth could slow in the first quarter of this year. 

Retail sales dropped for the third month in a row in February, and the trade deficit has grown to the widest level since 2008. US consumer confidence also dropped down from a 17-year high this week. 

A number of analysts have downgraded their outlook for January to March quarterly GDP, and the closely watched Atlanta Federal Reserve is projecting growth of just 1.8% in the first three months of the year. The question is whether the projected slowdown is due to seasonality, or symptomatic of something greater. 

A recent research piece from Longview Economics suggests there is increasing evidence that the US economy is close to the end of the cycle. However, according to its US Recession Indicator, recession risk is low. Harry Colvin, director and senior market strategist at Longview Economics, says: 

‘With a backdrop of (still) ample liquidity, and in the absence of warning signals from indicators which lead the economic cycle, the outlook for the US economy remains distinctly positive, at least on a six to 18-month timeframe’.

Colvin thinks the downgrade to the Atlanta Fed Q1 GDP estimate is largely seasonal. He believes this is consistent with the moves in the yield curve and higher equity market volatility.

The biggest risk to US outlook

The latest inflation data saw US consumer prices hit 2.2% growth year-on-year in February, rising from 2.1% in January. However, the personal consumption expenditure (PCE) deflator, which is the US Federal Reserve’s (Fed’s) preferred measure of inflation, is at 1.7% year-on-year for February, still below the 2% target.

Colvin says he is not expecting inflation to move higher in a disruptive way this year, and he forecasts three rate hikes in 2018. However, Longview’s senior market strategist warns that the biggest risk to the US economy and markets is inflation data moving higher much faster than expected, which would force the Fed’s hand to move more quickly on tightening policy. In turn, he argues, this would shorten the economic cycle and the equity bull market.

Forecasting the Fed

In March, the Fed raised its benchmark overnight lending rate by a quarter of a percentage point to 1.5-1.75%, as expected. It was the first press conference with Fed Chair, Jerome Powell, at the helm.

Most analysts project two further rate hikes in 2018, with the possibility for three depending on economic developments. Fed watchers are getting used to Powell’s leadership style at the US central bank, which is decisively different to that of his predecessor, Janet Yellen. Powell comes from a banking background and is the first chairman in 30 years who does not have a PhD in economics.

Longview Economics says history shows that overtightening of Fed policy can cause the end of an expansionary cycle. Some investors and analysts are concerned about the pace of Fed tightening, particularly as global markets have become significantly less stable than in 2017. The VIX index, also known as the Wall Street fear gauge, is nearly at 23, which is significantly above last year’s average.

Going against the grain

The US yield curve has flattened to a ten and a half-year low. A flattening curve is often seen as a precursor to a recession. Colvin says he would be surprised to see the 10-year yield move above 3%. He says everyone is short bonds, and sentiment is very bearish. Longview Economics conversely is overweight bonds.

Greenback past the trough?

The US dollar index is currently down nearly 13% since the highs at the end of 2016. Colvin is anti-consensus in his call that the greenback has reached a bottom. He argues that the weakness was about strong global trade growth and emerging market earnings growth, and some of that story is starting to fray at the edges.

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