Curmi & Partners

From projection to realisation

By Matthias Busuttil

Economic data in the US is showing that the optimistic projections for the recovery are finally beginning to materialise in tangible economic progress. The ISM Service PMI index reached 63.7 in March, versus expectations of 59.0, up from 55.3 in February, marking the fastest rate of growth in services activity with all industries seeing expansion. The reading came after the employment report for the month of March recording an increase in jobs of 916K, also exceeding expectations of 647K, showing that the labour market recovery is also underway.

Daily new virus cases have increased marginally in recent weeks. However, the virus fatalities have declined further. Covid immunity in the US is improving with 33% of the population having received the first dose and the daily rate of inoculations has reached a seven-day moving average of just over 0.8%.

Combined with loose monetary policy and the substantial fiscal impulse, the progress achieved in fighting the virus puts the US economy on track to expand strongly in 2021 outpacing other advanced economies. Consensus forecasts are pointing at a year-on-year real GDP growth rate of 5.7% this year compared to the expected growth rate for developed economies (ex-US) of c. 4.3%.

The accelerating economic recovery and the large fiscal stimulus has triggered concerns that the US economy will overheat, particularly in view of the change in the Fed’s reaction function from a pre-emptive inflation policy framework to its new Average Inflation Targeting framework where it will allow inflation to run above its 2% target, to compensate for periods of low inflation, before tightening policy. Several economists are arguing that, due to the strong cyclical forces, the reignition of inflationary pressures will force the Fed to change course and tighten policy earlier than it is currently expecting, possibly deterring growth and threatening the economic expansion.

Given these reflationary expectations, US Treasury yields have soared since the start of the year as markets are pulling forward expectations of policy rate hikes to early 2023, compared to the Fed’s own estimate indicating that rates will remain unchanged until after 2023.

The disagreement between market expectations and the Fed’s guidance predominantly hinges on the assessment of the economic output gap brought about by the pandemic. Moreover, the positive cyclical forces driving the strong economic momentum will unlikely be repeated or have the same effect next year.

Since the start of the pandemic, over two-thirds of the 25 million drop in people employed have been recovered. Whilst the recovery in the labour market is certainly a good sign, it is likely that the rate of improvement in the labour market will slow down, particularly since virus-sensitive businesses are rescaling their capacity given that conditions will take longer to normalise in these sectors.

Secondly, the unquestionably large fiscal spending is considered to be a temporary boost since the main elements of the programmes that are supporting demand, namely the household payments and the higher unemployment benefits, are one-offs and will eventually be wound down or expire. Fiscal spending is expected to be 11% of GDP in 2021 and fall to 5% in 2022. The lower fiscal impulse is expected to result in slower growth thus limiting the scope of above potential output.

US inflation is poised to exceed the target this year with the Core PCE rate possibly reaching 2.3% with the risk of an overshoot. As the short-term demand-supply imbalances, due to distortions brought about by the pandemic, are cleared and the temporary boosts to economic expansion fade, any output above potential is expected to re-balance to levels that are more synonymous with lower absolute levels of employment. Pass-through effects will therefore remain weak and, as a result, we similarly expect inflation to moderate to just above the 2% over the longer-term with any overshoot in inflation to be temporary and unsustainable.

Given that the level of employment is not expected to fully recover over the next twelve to twenty-four months, and that inflation will only moderately be exceeding the Fed’s target, our assessment is that the market is overestimating how soon policy rates will be hiked in the US. This is also based on the guidance provided by the Fed in that they would consider raising rates only after their quantitative easing programme is wound down. This would place the first possible rate hike more plausibly to occur in 2024.

While inflation, policy and growth dynamics remain positive in the US, we expect Treasury yields to continue to trail higher this year. Having said that, we expect such a rise in yields to be less abrupt going forward and to self-regulate in episodes of equity market corrections.


The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.