The Next US Recession

Over the summer months the current US economic expansion became the second longest on record, and if growth continues into next July will exceed the  last decade long upturn, which ended in 2001. Longevity, per se, does not mean a US downturn is inevitable any time soon but it is a curious fact that every decade over the past 150 years has seen a recession, be it mild as in 1990/91 ( lasting 8 months) or severe (18 months from 2007/09).

Recessions can have different catalyts, although it  often after the event that the process becomes clear.  In the past oil  price shocks have often precipitated a decline in US GDP but output  across the developed world is now less oil intensive than in the past. Moreover, the US is now the world’s largest oil producer and many expect it to become a net oil exporter over the coming years, so high oil prices may now be  neutral or even positive rather than negative for the economy.

Financial crises can also have serious effects on the real economy, as evidenced a decade ago, although the true extent of   any excess leverage and associated imbalances may not be fully understood ahead of the downturn. One concern currently flagged in the US is the relatively low yield on higher risk corporate bonds and the growth of ‘covenant-lite’ loans, with borrowers accessing credit  with fewer restrictions on collateral and payment terms.

Monetary policy mistakes are also often cited as causing recessions. The impact of interest rate changes on the economy is notoriously ‘long’ and varied’, making errors more likely, with central banks seeking to tighten sufficiently to keep inflation around target but ending up overdoing it , causing real activity to slow or even contract.

The Fed is currently immersed in a tightening cycle of course, and has raised rates eight times over the past three years. This cycle is unusual in many respects, however, in that the target rate is now a quarter point range rather than a stated figure. The starting point for rates was also very low (0%-0.25%) so that we are still at low rate levels three years on, both in nominal terms ( 2.0%-2.25%) and in real terms (around zero). In addition, the Fed is reducing its balance sheet by allowing some of the bonds it purchased under QE to roll off without reinvesting the proceeds, a policy dubbed ‘Quantitative Tightening‘. No one knows how this will pan out as it has never been undertaken before.

What is known is that the shape of the yield curve does have some predictive power in term of recessions, in that inversion ( longer dated yields fall below shorted yields) has pre-dated downturns in the past, although the time-lags have varied . For that reason the flattening of the 2’s-10’s yield spread in the US has caused much comment, particularly as it is currently in to 12bp. Indeed, the curve is actually inverted in the 3yr-5yr segment. The  3month-10yr spread has also narrowed appreciably, to 50bp, and the New York Fed uses that to model the probability of a recession, which has risen to 20%.

 

The market is  still expecting the Fed to raise rates further and another quarter point increase is given a high  probability at the FOMC meeting this month, taking it to 2.25%-2.5%, but beyond that rate expectations have changed; the futures market  for December 2019 is trading at 2.67% , implying one further rate increase next year, against an expectation of around 3% just one month ago, So the market is currently priced for a rate cycle that ends in 2019 and at a level very far removed from that indicated in the  September FOMC’ ‘dot plot’, which envisaged  rates at 3.0%-3.25% in a year’s time and a peak of 3.25%-3.5% in 2020.

So the big fall in longer dated yields ( the 10 yr has declined from 3.25% to 2.92%) can in  part be attributed to that change in rate expectations, in turn supported by a series of  weaker than expected readings in core inflation. Expectations can change, of course, and an upside surprise in wage growth would prompt a sharp reaction, with yields heading higher again. By the same token,  if the the recent upturn in weekly jobless claims was followed by a weak employment number longer term yields would no doubt fall further, as the Fed’s tightening intent is strongly predicated on  the view  that the labour market will strengthen further, taking the unemploymenr rate down to 3.5% next year.

The external environment for the US has also become cloudier, with weaker activity in China and a marked slowdown evident in the Euro Area. That said, America is essentially a closed economy so any pronounced deceleration in the pace of economic activity will likely be domestic in origin, be it from investment or consumer spending. Slower growth is generally expected next year but nothing more serious, although forecasters have a notoriously bad record at predicting recessions. The stock market is better, albeit erring on the opposite side, predicting some that never materialise.