Financial obligations ratio
In his speech, Dr. William Dudley explained that two of the three factors we discussed in the previous article of this series have abated. Housing prices have recovered to a large extent, leading to a fall in the number of homes moving into foreclosures and the number of households with mortgages underwater. A mortgage is said to be “underwater” if the balance of the mortgage loan is higher than the market value of the underlying home. Moreover, household debt levels have declined and lower interest rates have cut financing costs, leading to a decline in the household financial obligation ratio to 15.4% in the fourth quarter of 2013 against 18.1% in 2007. The household finance obligation ratio measures debt servicing cost as a percentage of disposable income.
While fiscal policy remains conservative, its projected drag has reduced to 0.5% of GDP in 2014 so far from around 1% of GDP in 2013. As most of the drag happened from January to April, the fiscal restraint should be very modest going forward.
On global economic conditions
Global economic conditions have largely remained the same. While Europe is recovering, Japan may slow down due to a large hike in consumption taxes effective April 1. China is also slowing down, and other emerging markets are struggling with their structural imbalances. The situation in Ukraine is also volatile. (Click here to read Market Realist’s take on the Ukraine crisis.)
Dudley’s outlook on the U.S. economy
With fundamentals of the economy improving and fiscal drag abating, Dudley expects the economy to grow at roughly 3% in the remainder of 2014, with further improvement in 2015. However, Dudley warned that business investments and the housing market should “kick-in more forcefully for the economy to grow at an above trend rate for a sustained period.”
Corporations’ operating performance and balance sheets have improved, and financing is available at low interest rates. While economic fundamentals appear strong, capital spending on equipment and software has risen by just 3.2% over the past four quarters and contracted in the first quarter. With improving trends in durable goods orders, Dudley feels that we may finally be seeing a pickup in business investments.
If the economy improves as per the Fed’s expectations, the Fed funds rate could see its first hike in six years in mid-2015. With more disposable money at hand, people’s propensity to spend will increase, giving rise to inflationary pressures. The Fed will increase interest rates to discourage spending and to ward off inflation. The rise in interest rates will affect all kinds of bonds (BND), including Treasury bonds (TLT), investment-grade bonds (LQD), and high-yield bonds (HYG)—though to varying degrees.
High-yield bonds (HYG) will be the least affected, as they have the lowest interest rate risk due to their higher coupon. Moreover, corporate bond yield spreads (for both high yield and investment-grade bonds) tend to contract in an improving economy, as the credit risk associated with these bonds fades while corporate performance improves. So investment-grade bonds are the second least affected asset sub-class, after high-yield bonds. Treasuries take the biggest hit in an improving economy. Investors can consider investing in ETFs such as the ProShares Short 20 Year Treasury (TBF) and PowerShares Senior Loan Port (BKLN) to protect themselves from rising interest rates.
To learn more Dudley’s view on housing and prices, move on to the next part of this series.