Compared to May month-end, U.S. Treasury yields are mixed with the two-year yield down one basis point to 0.60 percent while the 10-year yield is up 19 basis points to 2.31 percent. An improved economic outlook has been offset by increased uncertainty from geopolitical concerns. Nevertheless, the Federal Reserve and monetary policy remains a key driver in interest rates and financial markets.

On June 17, the Federal Reserve’s Open Market Committee finished a two-day meeting on monetary policy.  Overall, the Fed’s assessment of the economy was a little better than the April FOMC meeting, especially for the housing and labor sectors. Economic headwinds during Q1 were viewed as “transitory” and included the West Coast Port Strike, the stronger dollar and harsh winter weather. The policy statement suggested the Fed believes the economy will soon be healthy enough to withstand higher policy rates, likely by year-end. Projections by policy makers indicated the Fed Funds rate will finish 2015 near 0.625 percent and 2016 near 1.625 percent, which works out to six increases of 25 basis points.

June’s employment report was somewhat disappointing as the growth in nonfarm jobs was less-than-expected and there were an additional 60k in reductions to prior months reports. The unemployment rate dropped 0.2 percentage points to 5.3 percent as the labor force shrank more than the number of unemployed.  At the same time, the labor participation rate fell 0.3 points to 62.6 percent, the lowest it’s been since 1977. While job growth was weak, reaction to the report should be tempered as June is typically a month with larger seasonal adjustments.

Recent economic data indicates Q2 real gross domestic product growth will be a nice improvement over Q1’s negative real GDP growth rate of -0.2 percent. Estimates for Q2 range from 2.5-3.5 percent. Recent surveys on consumer sentiment suggest a sustained pickup in spending, which may support a September or October increase in rates by the Federal Reserve. While the Fed works to prepare the market for the first tightening in policy rates in nearly a decade, geopolitical uncertainty is complicating their efforts.

Greece is about out of time and there is much speculation on the impact of Greece defaulting on debt payments.  On July 5, over 61 percent of Greeks voted to reject requirements by the European Union and International Monetary Fund for more bailout funding. Polls indicate many Greeks want to remain in the EU, so it appears the “no” vote was more about trying to force a fresh round of negotiations versus anti-EU sentiment. Greece has already defaulted on a payment to the IMF and the country’s banking system is nearly out of cash. Capital controls have been implemented, which include limits on daily withdrawals from ATMs.

The European Central Bank is in a tough spot because it is the last line of defense against turmoil generated from a potential Greek exit from the Euro. At the same time the ECB is trying to maintain the integrity of the Euro financial system. Look for new offers to be extended to Greece from the European finance ministers. If they are rejected then Greece will likely exit the EU and we could see significant market volatility.

China is also adding to market concerns as Chinese stocks have been on the down escalator lately. In addition, they are seeing economic momentum slow and China’s central bank has responded by easing policy rates and bank reserve requirements. Puerto Rico is also a concern as their governor recently said they cannot pay back $72 billion in debt. There are several large payments coming due in the next few weeks. Some of these bonds are guaranteed by large U.S. bond insurers and a default could also trigger financial market volatility. Look for markets to be volatile and fragile as geopolitical issues remain center stage.

View on Interest Rates

The European Central Bank and Bank of Japan are continuing with quantitative easing and emerging market economies are looking to stimulate growth by lowering policy rates. Look for the dollar to hold on to its gains as geopolitical issues elevate market uncertainty. Provided U.S. economic momentum accelerates, labor gains continue and inflation remains contained, the Fed will likely start to tighten rates by year-end. Questions remain about how markets will react to the first tightening in policy rates since June 2006.

Risks to this economic outlook include a strengthening dollar as the Fed tightens, which may be a greater drag on growth. Also, it is not clear how the Fed will respond if there is a significant equity correction. We could see periods of extreme market volatility as debt defaults (Greece and/or Puerto Rico) ripple through investment portfolios.

Short-term rates continue to be driven by anticipated Federal Reserve monetary policy while long-term rates respond to inflation, economic growth, equity market volatility and geopolitical events.  The consensus forecast has the two-year U.S. Treasury yield finishing 2015 near 1.20 percent with the 10-year yield near 2.5 percent.

The above commentary is a summary of select economic conditions prepared for Northwest FCS management. It is being shared as a courtesy. As with any economic analysis, it is based upon assumptions, personal views and experiences of those that provided the source material as well as those that prepared this summary. These assumptions, conclusions and opinions may prove to be incomplete or incorrect. Economic conditions may also change at any time based on unforeseeable events.  Northwest FCS assumes no liability for the accuracy or completeness of the summary or of any of the source material upon which it is based. Northwest FCS does not undertake any obligation to update or correct any statement it makes in the above summary. Any person reading this summary is responsible to do appropriate due diligence without reliance on Northwest FCS.  No commitment to lend, or provide any financial service, express or implied, is made by posting this information.