First Quarter Real GDP Falls Off A Cliff; Market Shrugs

Market participants were caught off guard by last week’s final first-quarter real GDP reading of minus 2.9%. The lowest predictions were around minus 2%. However, with the end of the second quarter coming up, first-quarter GDP was too far in the rear-view mirror and stocks ended the day slightly higher. The ten-year yield moved down two basis points. The next day, the Personal Consumption Expenditure Deflator, the preferred inflation measure, printed at 1.8% and, again, the market took it in stride. Inflation creeping higher may have prompted St. Louis Federal Reserve President James Bullard to move his prediction for the first Federal Reserve rate hike to first-quarter 2015 (on the very early end of most predictions). This got the market’s attention a little more than the GDP print. Stocks bumped up slightly on the upbeat outlook intimated by a rate hike, but bond yields confusingly moved down further. None of this changes our portfolio positioning for higher interest rates six to 12 months from now. Steadily increasing inflation reinforces our prediction, as investors will need to demand higher interest rates to compensate for the erosion of spending power.