Gains in consumer spending and business investment helped the U.S. economy rebound more than forecast in the second quarter following a slump in the prior three months that was smaller than previously estimated.

Gross domestic product rose at a 4 percent annualized rate, the most since the third quarter of 2013, after shrinking 2.1 percent from January through March, Commerce Department figures showed today in Washington. The median forecast of 80 economists surveyed by Bloomberg called for a 3 percent advance. Consumer spending, the biggest part of the economy, rose 2.5 percent, reflecting the biggest gain in purchases of durable goods such as autos in almost five years.

Manufacturers such as Whirlpool Corp. (WHR) project sales will keep improving in the second half of 2014 as increasing employment lifts consumer confidenceand spending. The pickup in growth, as the expansion enters its sixth year, is among reasons Federal Reserveofficials meeting today may continue to pare monthly asset purchases while keeping interest rates low.

“The economy is looking pretty darned good,” said Stuart Hoffman, chief economist at PNC Financial Services Group Inc. in Pittsburgh, the only economist in the Bloomberg survey to accurately forecast the 4 percent gain in GDP. “The momentum for the second half is solid. The labor market is driving this growth, which means companies are looking for workers. The big picture looks a lot brighter and is probably more accurate” than the first-quarter GDP reading suggests.

David Fuller's view

The 2Q recovery is certainly more accurate in terms of the US economy than the 1Q drop which occurred during the harshest winter in many years, and even that figure has been revised upwards from the previously reported 2.9% decline to minus 2.1%.  US GDP growth is about where it should be in the sixth year following a severe credit crisis recession which inevitably led to widespread deleveraging.  It is also worth recalling that the US economy grew at 4.1% in 3Q 2013.    

Fed Chairman Janet Yellen will remain concerned about the smaller US workforce and lagging levels of middleclass and services industry salaries.  There are two reasons for this: 1) US big company corporate tax rates of 39% are obviously uncompetitive and a massive incentive to keep overseas earnings abroad; 2) The accelerated rate of technological innovation is replacing corporate jobs at a faster pace than ever before. 

Nevertheless, new jobs are being created and unemployment has fallen over the last seven months and counting.  However, competitive US corporate tax rates would bring more capital home and lead to additional hiring within the USA.  This would also increase US GDP growth.

What are the implications of stronger GDP growth and moderately increasing job creation for the US stock and bond markets?

The good news is that the US economy shows little evidence of outright deflation, which many pundits have predicted over the last five years.  Deflation similar to what Japan saw for so many earlier years and which the EU risks experiencing in the current environment, would drive government bond yields even lower, push up unemployment and hurt corporate profits.

It is hardly surprising that the US economy has avoided overall deflation given the massive amount of quantitative easing (QE) which Ben Bernanke brilliantly introduced.  Today, however, Yellen understandably wants to see further evidence of economic growth, less slack in the labour market, higher salaries and inflation which is no longer running persistently below 2%.  We are very likely to see all that over the next six to nine months, as the Fed Chairman is not yet signalling higher short-term interest rates, although she will end QE in October.  The only known factor which could seriously alter this outlook, in my opinion, would be a spike in the price of Brent crude oil.  Fortunately, this remains only an outside chance, despite all the political unrest in many oil producing regions.

In conclusion, Wall Street is still enjoying the ‘sweet spot’ in terms of accommodative monetary policy, moderate GDP growth, slack in the labour market, low bond yields and also reasonably low inflation.  However, the medium to longer-term risks for people holding longer-term bonds are definitely rising.  When US 10-Yr Treasury yields clearly exceed 3% that will be an early warning for the US stock market.  I also advise subscribers to keep an eye on the Merrill Lynch Treasury 10-Yr Total Return Index which is currently near former resistance.  It is a lagging indicator but when the sequence of rising lows since 1900 was tested last year is broken, fixed interest investors should regard that as a yellow caution signal which will turn red on a sustained break beneath last year’s low.  Please note: the Merrill Index above is always over a day behind and it may have already triggered the yellow caution signal as US Treasury yields had upward dynamics today.

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