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.

 

The US yield curve and the next recession.

The current US  economic expansion started in July 2009 and is already  much longer than the post-war average, although still  below the 10-year record duration set in the 1990’s, while closing in on the no.2 spot, set at 106 months in the 1960’s. A near term downturn is not inevitable but history suggests is likely at some point over the next few years. Forecasters are  poor at predicting recessions, and so there is interest in other potential signals. Equity markets generally turn down ahead of the real economy but they can and do fall without that precipitating a decline in GDP, so there is a risk of a false signal. The relationship between short term interest rates and long rates  (the yield curve) is another indicator of note, and in the US has proven  remarkably accurate ahead of the last seven downturns. Specifically, a yield curve inversion ( 10 year yields below 2 year yields or as some prefer, 3- month rates) has proven to be an excellent signal of a US recession a year or so ahead.

Why the success as a signal? Longer term  bond yields  carry a risk premium and are therefore generally higher than short rates, and may also be influenced by specific demand/supply factors at different maturities. For example, banks generally buy shorter term bonds, while pension funds seek much longer maturities. Expectations about the path of short term rates over the period are the most important factor, however, which in the US amounts to expectations about the Fed’s monetary policy and inflation. If policy is tightened in response to a booming economy or above target inflation longer term rates tend to rise, albeit by less than the move in short rates (the curve flattens) and may eventually invert if the market believes that  short rates have peaked and will eventually start falling . The inverted yield curve may also help precipitate a downturn because it dampens margins for the banking sector (banks borrow short and lend long)

The US yield curve is not currently  inverted but it has flattened appreciably; the 2-10 year spread has fallen from a peak of 260 basis points in late 2013 to just under 60 now, having started the year at 135.The recent pace of flattening has prompted much market debate  particularly as short rates are still very low by historical standards.

The Fed is  widely forecast to raise short rates again as early as December , and has signalled that it expects to tighten further in 2018, yet  10-year yields have fallen in absolute terms over the past month and are well below the highs in yield recorded earlier in the year.Maturing Treasuries are no longer being fully reinvested and, all things equal, the Fed’s decision to steadily reduce its holdings of bonds might be expected to push yields up. Some argue that issuance is shifting towards  the shorter end of the yield curve, so supporting longer dated paper, which in any case is still in strong demand as a ‘safe’ asset and  such assets are relatively scarce as central banks elsewhere are still buying.

A bigger factor may simply be that the market is convinced, at least for now, that  US inflation will continue to disappoint the Fed and remain below the 2% target, so implying that short rates will not rise to the extent the FOMC expect. The current  core inflation rate is only 1.3% ( the consumption deflator ex food and energy)  and was last (briefly) above 2% in early 2012. Most Fed governors believe that inflation will eventually start to accelerate as wages belatedly respond to the extremely low unemployment rate, but that view is not universally shared. Indeed, the minutes from the most recent FOMC meeting point to growing doubts as to whether sub-target inflation is indeed ‘transitory’.

Yield curve models are currently giving a low probability of recession in 2018 it has to be said ( the New York Fed’s model indicates around 10%) but the yield curve certainly bears watching given the recent trend.