In the first quarter the U.S. economy grew 1.8% on a seasonally adjusted basis compared to 3.1% in the previous quarter. The latest estimates indicate a significant slowdown in the economic recovery. The main driver for this slowdown was the drop in government consumption expenditures and gross investment. Real federal government consumption expenditures and gross investment decreased, mainly due to a sharp decline in national defense spending which dropped 11.7%. However, we expect the government sector to contribute positively to economic growth throughout the year.

Personal consumption expenditures, private inventory investment and nonresidential fixed investment positively contributed to the economic growth in the first quarter. For the remainder of 2011, consumption is expected to continue as the main driver of economic activity. The economy will continue to suffer from ongoing deleverage due to high unemployment and strict credit conditions. However, a steady increase in personal income, government support programs and tax incentives will support personal spending.

Continuing Struggles in the Housing Market and Labor Market

Labor market conditions are improving but at a slow pace. The U.S. economy created approximately 1.3 million new jobs in the last 12 months but it was not enough to alleviate high unemployment. While the unemployment rate declined one percentage point from 9.8% to 8.8% in only four months, most of this decline can be attributed to a fall in the participation rate. These trends suggest that a mismatch exists between the demand for labor and skills of the unemployed. In this scenario, the unemployment rate will decline at a slower pace than in previous recoveries.

Even with the economy on positive ground again, housing demand is up in the rental market because the slow pace of job creation heightens uncertainty and housing prices continue to fall in many markets. In addition, although affordability ratios are very attractive for buyers, tighter loan conditions are inhibiting demand from would-be buyers. In line with BBVA Compass' expectations, the slight improvement in home sales observed in the last two quarters has helped reduce the excess supply to half of its prior peak. In the second half of 2011, we expect an uptick in the residential market as economic activity and employment growth accelerates.

The Price of Oil's Effect on Inflation

Political events in the Middle East and North Africa are keeping oil prices above $100 per barrel. BBVA Compass' baseline scenario assumes that the increase in energy prices is temporary and therefore will have a limited effect on consumption, business activity and inflation. This period of higher oil prices and uncertainty counterbalance the upside risks to growth that the bank previously anticipated. The baseline scenario of a temporary oil price spike also assumes that political conditions return to normal within a few months. The BBVA Compass economic team has witnessed similar episodes in various oil-producing countries in the past, and the impact on U.S. economic growth and inflation remained limited. While higher oil prices will likely increase average inflation to 2.8% in 2011, the pass-through effect to core inflation will be limited.

Looking Forward

While BBVA Compass expects the Federal Reserve to complete its current large-scale asset purchase program at the end of the second quarter of this year, the reinvestment of principal from maturing assets will continue until financial and economic conditions warrant a change in policy, probably through August or September. The cessation of principal reinvestment is one of the first steps of its exit strategy. Assuming that the inflation rate remains within the Fed's comfort zone and longer-term inflation expectations are stable, the Fed will indicate a future change by deleting the wording "extended period" from the statement a couple of meetings before the first rate hike. Our baseline scenario assumes a first rate hike in March 2012.

Overall, our forecasts indicate 3.0% growth in the U.S. economy in 2011, but downside risks are greater than the upside potential. The inflation rate will increase to 2.8% in 2011 while core inflation remains under 2%. The Fed will be in no rush to raise interest rates in an environment with substantial resource slack, limited core inflationary pressures and stable longer-term inflation expectations. The timing of policy actions (balance sheet normalization, in particular), will depend on the evolution of data during the summer.

Fixed vs. Floating?

By Karen Dixon
Private Banker, Houston

As we approach mid 2011, interest rates remain at surprisingly low levels. Many borrowers continue to take advantage of this unexpected gift by using floating rate loans in debt portfolios in order to minimize borrowing costs. However, much in the way one diversifies investment portfolios to minimize risk; one should consider the importance of also diversifying debt portfolios to hedge the possibility of rising interest rates by fixing a portion of long term debt.

In addition to economic growth and inflation possibly driving interest rates higher, one must be cognizant of the burden of the US budget deficit and the need for record US Treasury issuance. Eventually higher interest rates may be necessary to entice investors to purchase U.S. debt. Of particular near term concern for interest rates is the end of the Federal Reserve's bond purchase program at the end of June. The exit of a key purchaser of Treasury and Mortgage bonds may finally be the catalyst that propels interest rates higher.

All of these components offer signals in varying degrees of potentially rising rates and should be evaluated collectively as key indicators of growth and inflation. So, the question becomes, "What should one do to hedge against the possibility of an increasing interest rate environment?"

Fix long term debt secured by long term mortgages. Most BBVA Compass clients have mortgage debt secured by primary residences or second homes. We are at a point historically where long term rates are as low as most of us have ever seen. Bankrate.com compiles weekly surveys of mortgages and points to rates at 26 year lows over the last 5 months. If you have not refinanced your home into a fixed rate for the term you plan to have debt outstanding, it is certainly time to consider. Many clients find the after tax cost of mortgage dollars to be their most reasonable cost of capital.

Consider Interest Rate Swaps. An interest rate swap is an agreement between two parties (known as counterparties) in which one party agrees to exchange (or "Swap") a floating rate on a common notional amount, or principal balance, for a fixed rate. The contract is separate from a loan, however, and allows a borrower to establish a fixed rate for a loan that is currently floating. A distinguishing component of a swap is the value created (or lost) in the contract itself. If the market for fixed rates is higher than the rate on an existing swap, the contract has imbedded value if unwound prior to expiration. Similarly, if fixed rates fall and the contract is unwound prior to expiration, there is a cost to unwind. Many clients find this a useful tool to hedge interest rate exposure; however, as with any derivative contract, it is important to consult your team of advisors prior to execution to confirm suitability.

Terminate any Consumer Installment Debt. With the probability of rising rates over the next 12-24 months, it is important to repay any floating rate debt that has the possibility of rising at an accelerated rate. One example of this is credit card debt. Clients should consider a HELOC as a viable alternative to any installment debt. In Texas, a homeowner can borrow up to 80% of the appraised value of their home less the first lien (if any). One caveat is that the HELOC cannot exceed 50% of the value of the home regardless of the first lien. Interest on a HELOC is often tax deductible and many carry the option of fixing a portion of the outstanding balance in the event rates begin to rise.

Regardless of the direction you choose, it makes sense to evaluate floating rate debt and consider how best to hedge when the tide turns and rates begin to increase.

Karen Dixon is a senior private banker at BBVA Compass Bank Wealth Management Group. BBVA Compass does not provide tax planning or legal advice to its customers. Customers considering implementing specific recommendations should consult their tax and legal advisors. BBVA Compass is a trade name of Compass Bank, Member FDIC.