Data during the week continued to suggest that the economy lost some momentum in the third quarter of the year. Retail sales fell by 0.1% in September, following a 0.2% gain the month before. This was mostly due to weak vehicle and gas sales though, and the so-called core retail sales, which are the most closely linked to real personal spending, were up by a decent 0.5%. Still, this leaves in place a picture of only modest consumption growth in Q3. Indeed, we think that real spending grew by 1.8% in Q3, around the same pace as in Q2, suggesting that consumption continued to be hampered by the rise in taxes that we saw in the beginning of the year. All in all, we expect that this week’s Q3 GDP report will show that the economy grew by just 1.8% qoq saar, down from 2.5% in the previous quarter. This probably also explains why we only saw a modest increase in manufacturing production in Q3. Indeed, manufacturing production grew by just 0.1% in September, and by 1.2% qoq saar during the third quarter as a whole.
However, data about the fourth quarter seems to suggest that the manufacturing sector will pick up steam in coming months. Indeed, the Chicago PMI rose from 55.7 to 65.9 in October, the highest level since March 2011. Meanwhile October’s ISM report edged up by two tenths to 56.4, marking the fifth monthly increase, and bringing manufacturing activity to the highest level since April 2011. Working in the other direction though, the Conference Board’s measure of consumer confidence fell particularly sharply in October (from 80.2 to 71.2) as the government shutdown weighted on confidence. What is more, ADP private employment showed that just 130K jobs were created in October, the slowest pace of job growth since April. Still, we think that the negative consequences of the government shutdown will only have a transitory effect on the economy and expect the data to improve again from November onwards. This would be in line with our view that the economy will accelerate modestly in Q4, as the fiscal drag slowly fades.
October’s Fed statement was a bit more hawkish than expected. Granted, FOMC members became slightly more negative on the economy, stating that information ‘generally’ had suggested that economic activity had continued to expand at a ‘moderate pace’, while the recovery in the housing market had ‘slowed somewhat’. But this was offset by the Fed no longer being concerned about tightening financial conditions, as was the case in September. This suggests that the FOMC currently feels comfortable about the level of longer-term yields. Indeed, the statement continued to suggest that a tapering remains on the cards, though, as in September, the Committee wanted to see more evidence that progress will be ‘sustained’ before adjusting the pace of its asset purchases. Given the effects of the government shutdown, we doubt that this point will be reached during the December meeting. As such, our base case remains that the Fed will start to reduce its QE programmes in March of next year.
It was a bad week for US Treasury prices falling following a week of gains. In the beginning of the week, yields moved broadly sideways, but this changed on Wednesday when the FOMC statement was perceived to be slightly more hawkish than expected. On Thursday, the unexpected surge in the Chicago PMI led to a further rise in yields, while Treasuries received another blow on Friday, when the ISM manufacturing index unexpectedly rose further. All in all, 10-Y yields rose by 12bp to 2.62% during the week. Looking further down the road, we continue to think that yields will rise modestly in the final months of the year, though the upside for yields is limited as the data are likely to give a mixed picture of the strength of the recovery due to the effects of the government shutdown. Next year, we think that yields will rise to 3.75%, as the Fed from March onwards gradually unwinds its QE programmes, against a backdrop of a strengthening recovery.