New Lows For Consumer Defaults Support The Case For Normalizing Fed Policy And Rising Bond Yields

The May U.S. employment report restored investor confidence in the U.S. economy. Not only did nonfarm payrolls increase by 280,000, easily beating economists' consensus forecast looking for 230,000 newly created jobs, but average hourly earnings growth also surprised on the upside by improving to 2.3% year-over-year. The resumption of healthy payroll creation and wage growth substantially reduced investor fears that there may have been more to first-quarter GDP weakness than unusually severe winter weather and the West Coast port strike could explain.

Equally significant, the healthy May employment report reinforces the longstanding trend of improving household credit conditions in place since the U.S. economic recovery began in mid-year 2009. Consumer credit defaults peaked at 5.5% in May 2009, according to the S&P/Experian Consumer Credit Default Composite Index, five months before the U.S. unemployment rate peaked at 10.0% in October 2009 (see chart 1). The steady stream of healthy nonfarm payroll gains has put persistent downward pressure on unemployment, which has helped diminish consumer defaults on outstanding debt, thus culminating in the lowest default rate on record dating back to July 2004.

As the Fed now ponders the first rate hike in nearly 10 years, the timing of the potential accommodation reduction seems appropriate considering that consumer credit defaults are actually lower today than 11 years ago. In fact, the April reading of 0.97% for the S&P/Experian Composite Consumer Default Index is marginally below the 1.07% level recorded in June 2006 when the Fed concluded its prior tightening campaign, before the financial crisis and recession subsequently saw defaults skyrocket to the May 2009 high. Therefore, based on the latest unemployment and default data, the Fed can easily justify an initial incremental step toward normalizing monetary policy sometime in the second half of 2015, in our view. 

U.S. Consumer Credit Defaults vs Unemployment

Building on the improvement in unemployment and consumer creditworthiness, automobile sales have simultaneously strengthened to new cycle highs. Annualized U.S. light vehicle sales rose to 17.7 million units in May, the strongest sales rate since July 2005. Financial media have suggested that auto sales are likely being promoted by historically low interest rates. These rates enable consumers to purchase more expensive cars--with loan terms that can be extended to 84 months--than they might otherwise afford largely due to low auto loan interest rates. To some extent current conditions, characterized by historically low consumer credit defaults and low borrowing costs, are similar to the extremely favorable financing terms that existed at the start of the prior Fed tightening cycle in 2004. The big difference today is that a small bubble may now exist in the automobile financing market, as opposed to the major bubble in the real estate at the tail end of the last business cycle that included nearly catastrophic risks for the entire U.S. financial system.

In anticipation of potential rate hikes by the Fed, the yield on the 10-year U.S. Treasury note rose to 2.50% on June 10, the highest since late September 2014. Should personal consumption continue to improve at a pace in line with the impressive auto sales data, bond yields will likely continue to press higher as the case for monetary policy normalization builds over the balance of 2015.

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