A Review of the Advanced Q2 U.S. GDP Report

In my Forex Trading Guide for the Advanced Q2 U.S. GDP report, I concluded that:

“Overall, the available economic reports, are pointing to a likely sharp rebound in Q2 GDP growth. In addition, GDP forecasts by some of the more respectable institutions are also pointing to a pickup in GDP growth, at least on an annualized quarter-on-quarter basis.”

And my conclusion still stands out… in a twisted kind of way. This is so because Q2 2016 U.S. GDP grew by 1.2% on an annualized quarter-on-quarter basis, which is faster than Q1’s downwardly revised 0.8% pace of expansion (1.1% original final estimate).

However, I also noted in my 4 Takeaways from the July FOMC Statement that there were “No upbeat remarks on the expected rebound in Q2 GDP growth, so do be careful if you’re planning to trade this Friday’s advanced Q2 GDP estimate.”

Well, that turned out to be a very insightful, um, insight because the actual 1.2% reading is waaaay below the consensus of 2.6%, which is why the Greenback dropped as a result. But why was GDP weak? What happened? Time to find out!

USD Index: 15-Minute Forex Chart

USD Index: 15-Minute Forex Chart

The Drivers

The main drivers for Q2 GDP growth were consumer spending (a.k.a. “personal consumption expenditure”) and net trade. Consumer spending jumped by 4.2% in Q2 (+1.6% previous), adding 2.83% to GDP growth (+1.11% previous). As for net trade, it added 0.23% to GDP (+0.01% previous), thanks to exports expanding by 1.4% (-0.7% previous) while imports contracted by 0.4% (-0.6% previous).

The Drags

As for the drags to GDP growth, we have another slump in gross private domestic investment, as well as the slide in government spending. Gross private domestic investment dropped hard by 9.7% (-3.3% previous), which marks the third consecutive quarter of contractions and subtracted 1.68% from GDP. Meanwhile, government spending fell by 0.9% (+1.6% previous) after five straight quarters of positive contributions, thereby subtracting 0.16% from GDP growth (+0.28% previous).

It is worth noting that the decline in gross private domestic investment was broad-based, with business fixed investment, residential fixed investment, and business inventories all in decline.

Residential Fixed Investment

Residential fixed investment declined by 6.1% (+7.8% previous), which subtracted 0.24% from GDP (+0.29% previous). This is a bit concerning since it’s the first decline since Q3 2014 and could mean that the housing market is cooling down.

Business Fixed Investment

Business fixed investment, meanwhile, continued its slide for the third quarter running (-2.2% vs. -3.4% previous), subtracting 0.28% from GDP, which is less than the -0.44% drag from Q1, but still a drag regardless.

The continued slide in business fixed investment is bad because it’s a measure of business spending. And contractions in business spending on factories, machinery, commercial buildings, etc. have long-term negative implications for the U.S. economy, which is likely why the Fed has been singling it out as a major concern in the past couple of FOMC statements. As to why companies are not in the mood to spend, even the Fed admits that it doesn’t really know the reason, as revealed in the minutes of the June FOMC meeting.

Inventory Investment

I went off on a tangent there. Getting back on track, business inventories also declined and happened to be the biggest drag, subtracting 1.16% from GDP growth (-0.41% previous). Interestingly enough, if we strip away the large drag from inventory investment, then the U.S. economy grew by 2.38%, which is just below the consensus reading.

As to what the large drop in inventory investment means, there are two ways to look at it. If you’re an optimist, then the drop in inventories was likely due to stronger-than-expected demand, which is good. Better still, it would also mean that production would likely get a boost next quarter since businesses would need to restock their depleted inventory levels. This view is supported by the strong consumer spending and the bounce in exports during Q2.

From a more pessimistic perspective, however, the drop in inventories could meant that the persistent slide in business fixed investment is finally coming home to roost. This view is not supported by the industrial production numbers, however, since overall output was higher during the Q2 months relative to the Q1 months, as I noted in my latest U.S. economic snapshot.

The BEA made some mistakes?

The previous reading was revised to a much lower 0.8% to reflect a much harder slump in gross private domestic investment (-3.3% vs. -1.8% originally), but that’s not all.

Officials from the Bureau of Economic Analysis (BEA), the government agency that’s responsible for compiling the GDP report, had some press time yesterday. And one of them told reporters that the BEA “did find some evidence of residual seasonality both over the most recent 10-year period and over a 30-year period.”

In simple English, the BEA official is saying that there was a problem with the way the BEA’s seasonal adjustment calculations. For those who don’t know, the GDP numbers are adjusted for seasonality in order to better see the underlying trend.

Anyhow, this flaw in the seasonal adjustments is the reason why the BEA said that it will start releasing seasonally-unadjusted GDP data by 2018. The aforementioned flaw is also the reason why we got this:

U.S. GDP Revisions

U.S. GDP Revisions (q/q Annualized)

Look at all them revisions, yo! And that’s just the 3-year data that’s available in the GDP report. And there’s probably much more since the BEA did say earlier that they found these flawed calculations “over the most recent 10-year period and over a 30-year period.”

What’s really interesting here is that the Fed decided to hike rates back in December when Q4 2015 GDP only grew by 0.9%. And I’m just guessing here, so don’t quote me, but the Fed was probably aware of the revisions, as well as the likelihood that GDP grew at a pace below consensus. It certainly explains why the Fed decided to present a very neutral tone on monetary policy during the most recent FOMC statement, despite delivering lots of other hawkish remarks.

And as I said earlier, I warned in my write-up for the FOMC statement that there were “No upbeat remarks on the expected rebound in Q2 GDP growth, so do be careful if you’re planning to trade this Friday’s advanced Q2 GDP estimate.” In hindsight, other forex traders probably had the same observation and some may have acted on that observation by dumping the Greenback as a preemptive move.

What the market thinks

Okay, it’s time to survey the damage. As I noted in my write-up for the July FOMC statement, the CME Group’s FedWatch toolshowed that the market has priced-in an 18% probability for a September rate hike, down from 19.5% the day before the FOMC statement.”

In the aftermath of the disappointing GDP reading, however, it dropped to just 12.0%, as you can see below.

CME Group: FedWatch Tool

CME Group: FedWatch Tool (September 2016 Meeting)

That’s not the end of it, though. Looking at the probability of a 25 bps rate hike by July 2017, the market thinks that there’s only a 34.7% probability of a rate hike and there’s even a 1.1% probability of a rate cut. Before the GDP report came out, the market had priced-in a 40.3% probability of a rate hike and no chance for a rate cut.

CME Group: FedWatch Tool

CME Group: FedWatch Tool (July 2017 Meeting)

What the market thinks is not equivalent to what Fed officials will do, however. Although Fed officials do seem to keep an eye on what the market thinks. One example is when “some members expressed concern that the likelihood implied by market pricing that the Committee would increase the target range for the federal funds rate at the June meeting might be unduly low,” as revealed by the minutes of the April FOMC meeting.

I know I already asked this question in my write-up for the July FOMC statement, but I’ll ask it again anyway, given the turn of events. So, did the GDP report make you reconsider your own rate hike expectations? Are you still expecting a rate hike within the year? If you are, how many rate hikes do you think there will be, given that there are only three FOMC meetings left? Share your thoughts by answering the poll below!

 


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