GDP is Revised Down, Inflation Moves Up

First quarter real GDP growth (quarter-over-quarter, annualized) was revised downward from the prior estimate of 0.1% to negative 1.0%, a downside surprise. As usual, the day after the most recent GDP estimate is released, the Personal Consumption Expenditure (PCE) Deflator is published. PCE is the preferred indicator of inflation monitored by the Federal Reserve, and printed in line with expectations at 1.6% (annualized). Some have argued the contraction in first-quarter GDP growth has “coiled the spring,” and most estimates point toward a 3%-4% annualized growth rate for the second quarter. There is general consensus about the direction of GDP, whereas expectations for the direction of PCE are mixed. Broadly speaking, however, the expectation is that demand will accelerate in Q2, which, along with higher home prices and rents, will push PCE higher. For bond portfolios, higher GDP growth and higher inflation would, in theory, mean higher interest rates. But 2014 has puzzled market participants. Interest rates have declined noticeably since the beginning of the year despite robust indicators of growth such as job creation. It remains to be seen whether the decoupling of interest rates from economic fundamentals will come to an end and rates will rise or if another surprise, perhaps from the global markets, will drive interest rates down even more.