Data during the week showed that wealth effects continue to underpin consumption. Indeed, retail sales rose by 0.6% in May. What is more, core retail sales, which exclude cars, gas and building materials, rose by 0.3%, building on a 0.2% increase the month before. All this adds to evidence that the US consumer is resilient to the rise in taxes that we saw in the beginning of the year, as past rises in house and equity prices boosted household wealth, while the labour market also continues to recover. Indeed, initial jobless claims fell by 12K to 346K in the week ending June 8, keeping the series on a downward trend. Still, the trend in core retail sales has eased somewhat over recent months, in line with our view that consumption growth will be somewhat weaker in Q2 than in Q1. Meanwhile, the Un. of Michigan´s consumer sentiment index fell from 84.5 to 82.7 in June, showing some payback for last month´s firm gain. That said, an ongoing recovery in the housing and labour market should help confidence to rise in the remainder of the year.
The fact that consumption is showing resilience to the increase in taxes most likely also helps to explain why the NFIB small business optimism index rose from 92.1 to 94.4 in May, bringing it to the highest level in a year. Small businesses are responsible for the lion’s share of hiring. So the improvement bodes well for the labour market recovery later in the year. On a less positive note, industrial production was flat in May (was -0.5%). Although this largely reflected a sharp drop in utilities production, which can be volatile, manufacturing production rose by just 0.1% in May after a 0.4% drop in April and a 0.3% decline in March. As a result, the 3mo3m growth rate fell to -0.1% in May, down from 0.5% the month before, keeping it on a downward trend. This supports our view that the economy will slow a bit in Q2 compared to Q1. Still, we expect to see an acceleration in growth in the coming quarters as the fiscal headwinds ease and cyclical momentum continues to build.
Financial market participants will closely watch this week’s Fed meeting for any clues about when the Fed will start to reduce its QE programmes. We do not expect to see large changes in the press statement though, while FOMC members’ economic projections should also remain broadly unchanged. As such, most attention will go to the post-meeting press conference. Here, we expect Chairman Bernanke to stress that a QE tapering will depend on the evolvement of the dataflow, but that the economic recovery is not strong enough to justify an imminent reduction. Moreover, the Chairman is likely to stress that a reduction in the Fed’s QE programmes is not an automatic journey to the exit, but that each stage of the process will depend on the outlook for unemployment and inflation. Our base case remains that the Fed will announce a tapering off in December (though a September move cannot be ruled out completely), which should be followed by another reduction March, with purchases not coming to a halt until the middle of next year.
It was a good week for US Treasuries, with prices rising for the first time in seven weeks. In the beginning of the week, though, yields continued to move higher, as S&P raised its outlook on the US rating from negative to stable, while the BoJ refrained from implementing additional stimulus measures. These developments reinforced investors´ belief that a reduction of the Fed´s QE programmes was around the corner. However, the mood changed in the second half of the week. Indeed, an article in the Wall Street Journal that argued that a reduction in the Fed´s asset purchases would not mean that the Fed would end its QE programmes at once, or raise interest rates calmed investors´ nerves. As a result, yields fell to 2.13%, 5bp lower than the end of the previous week. Although we think that a large part of the Fed´s intention to start reducing its QE programmes later in the year is by now priced in, yields should rise higher in the second half of the year as economic momentum picks up. This explains why we see 10-Y yields at 2.5% at the end of the year .