By the end of the first quarter, U.S. economic data began to improve somewhat from what had been winter-related economic weakness. After disappointing results from various sectors of the U.S. economy, higher auto sales, improving business activity, and overall job creation that is generally in line with forecasts have helped shape expectations for a comparatively better spring.
How the yield curve might react to better growth
In our view, as the U.S. economy continues to strengthen in 2014, Treasury yields, particularly in the intermediate part of the yield curve, are likely to move higher. However, we don’t believe rates are likely to rise so quickly that the shift will undermine economic growth.
Employment factors signal the strength of the recovery
We continue to think that, with the economy looking better, the key to the pace of normalization can be found in the labor market. Chair Yellen repeated her view that much of the decline in labor participation is cyclical rather than structural. This view is reflected in the March labor report, as it showed a rise in participation that one would expect from a normalizing economy.
Wage growth rates could be the fulcrum of coming policy shifts
The questionable factor in this formula for normalization, we believe, is rising wages. If Yellen is correct, the economy should be able to grow strongly for a longer period before inflationary pressures emerge in the labor market. But if she is wrong and participation does not continue to rebound, higher wages among a smaller population of skilled workers could begin to push up labor costs that may not be offset by higher productivity. If this should come to pass, we think the stance of monetary policy would have to shift quickly, potentially leading to a faster and more dramatic rise in rates than the market currently expects.