Ultra-Low Rates Could Last Another Decade [iShares Barclays 20+ Yr Treas.Bond (ETF), ProShares UltraShort Lehman 20+ Yr(ETF)]

ratesCris Sheridan: Although many economists anticipated the official measurement of US economic growth in the first quarter to undergo another downward revision, they certainly weren’t expecting the huge plunge to negative 2.9%, which came in well below consensus estimates.

With such a big surprise to the downside, did the markets crash? Nope. Why not?

In short, the consensus view holds that Q1 GDP growth was largely affected by “transitory factors” and will see a much stronger pickup in the second quarter, as Janet Yellen stated in her recent press conference:

Although real GDP declined in the first quarter, this decline appears to have resulted mainly from transitory factors. Private domestic final demand—that is, spending by domestic households and businesses—continued to expand in the first quarter, and the limited set of indicators of spending and production in the second quarter have picked up. The Committee thus believes that economic activity is rebounding in the current quarter and will continue to expand at a moderate pace thereafter. Overall, the Committee continues to see sufficient underlying strength in the economy to support ongoing improvement…

Thus, the consensus view is that the contraction in first quarter GDP growth was an outlier and that, with a stronger rebound in the second quarter, the economy will not go into recession (technically defined as two consecutive quarters of negative growth).

Our own recession models support this view and show that the probability of recession is still quite low, with incoming data and leading economic indicators also in support of a more optimistic view.

If an economic recession doesn’t drag down the stock market, what other factors need to be considered?

Outside of unforseen exogenous shocks, two of the most important influences of market behavior are: 1) a sudden or ongoing increase in the price of oil due to geopolitical concerns or 2) the timing of interest rates hikes by the Federal Reserve.

Given the strong influence oil prices have on economic growth, recent events in Iraq pose a significant threat to the global economy should prices spike higher. In a recent piece, James Hamilton estimated “an oil price in excess of $150 a barrel” should ISIS gain control of key oil fields and cause major disruption.

Although he doesn’t think the US is as vulnerable to an oil shock today as in the run-up to the last financial crisis, clearly further significant increases in the price of oil due to geopolitical tensions will drag on economic growth and put pressure on the stock market.

Regarding the second main concern, the Fed is expected to fully withdraw its current program of quantitative easing (QE3) by the end of this year and has attempted to reduce the potential negative impact this may have by gradually tapering their level of accommodation. Whether this will give the market time to adjust and by how much remains to be seen, however, putting QE aside, the more important variable of monetary policy is the level of accommodation provided by the Federal Reserve through low interest rates.

Since low interest rates facilitate borrowing, leverage, refinancing, and consumption—not to mention the calculation of future cash flows for various assets—changes in interest rate levels have profound effects on both the stock market and economy.

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