Goldman sees 'upside risk' for US economy

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Remember last year when China devalued its currency and the market went nuts? Well, so much for that.

The subsequent tightening in financial conditions that came with the bold currency move has vanished, according to Goldman Sachs. The bank said its proprietary Financial Conditions Index has returned to its August 2015 level, providing a bright spot in an economy that otherwise has been lackluster.

"Each of the key components (in the index) — long rates, the dollar, equity prices and credit spreads — has retraced most or all of its prior deterioration," Goldman economists Jan Hatzius and Chris Mischaikow said in a note to clients. "The implications for U.S. growth are quite positive."

At a time when markets have been prone to quick shifts, banking on a longer-term prospects is risky. Goldman, though, sees reason for optimism.

"We think financial conditions have turned from a significant downside risk to our growth forecast in early 2016 to a moderate upside risk at present," Hatzius and Mischaikow said.

Whereas the tightening conditions were subtracting a full percentage point from Goldman's U.S. gross domestic product outlook, the change could add a half to a full percentage point.

The dollar's decline in particular has been a boon across the board. The U.S. dollar index has fallen 4.7 percent in 2016 and is down 3.5 percent in the 12-month period. Bond yields are broadly lower as well, with the benchmark 10-year note off 22.2 percent this year to 1.78 percent.

Equity markets have responded in kind with the S&P 500 surging 11.4 percent in the past three months and now just above its year-ago level. The Dow briefly reclaimed the 18,000 mark, the first time that's happened since July.

In addition to the China devaluation, markets have been vulnerable to shifts in Fed policy. The U.S. central bank in December approved a quarter-point hike in its interest rate target, the first in more than nine years, setting off another wave of market upset.

Interestingly, Goldman holds an out-of-consensus view that the Fed will hike three more times in 2016. Current market expectations are that the Fed will move just once this year, in December. Even the "dot plot" of individual Federal Open Market Committee members' expectations sees just two increases.

The Goldman economists acknowledge that risks to their rate forecasts are "clearly on the downside" but believe the Fed will "tighten monetary policy by significantly more than discounted in the bond market."

Goldman's optimism runs counter to a generally pessimistic outlook from multiple other quarters.

The International Monetary Fund just shaved its growth projections both globally and for the U.S., for which it cut 0.2 percentage point on its 2016 forecast to 2.4 percent and 0.1 percentage point to 2.5 percent for 2017.

In a statement Tuesday, the American Institute for Economic Research, a libertarian think tank, warned of "heightened risk" for the U.S. economy, though it believes it is "too early" to forecast a recession. The Atlanta Fed GDP tracker sees the economy gaining just 0.3 percent in the first quarter.

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