Some recession indicators have flashed

On 22nd March, the US Treasury yield curve inverted, causing concern in financial markets and acting as a warning to investors. Th is movement could imply that US bond market investors believe that the Fed made a policy error by over tightening. A yield curve inversion has in the past been a predictor of recession.

An inversion of a yield curve occurs when the yields on a 10-year US Treasury note fall below the yield for a 3-month US treasury bill. In normal circumstances, the longer the investment term the higher the yield expectations as investors tie their money up for longer. If the interest paid on short duration bonds is higher than on long duration bonds, this indicates that central banks are expected to cut interest rates due to weak economic conditions.

The yield curve does have some history of false signals. Other measures of economic activity that cover a wide range of data do not point to a US recession at this time. It could be argued that the unprecedented levels of quantitative easing and low levels of interest rates have complicated the yield curve by distorting traditional curve dynamics. Some economists suggest an inverted yield curve in these post QE times may just be a signal that we have hit peak interest rates which are now most likely to fall in the near term. The yield curve inversion may be the result of a weaker economic outlook and not a predictor of a recession within the year.

Despite these views, the inversion of the yield curve was a key trigger for Citigroup to issue a recession warning for the USA. The bank advised clients to start winding down their exposure to risk asset. This was something we started to action back in January. Citigroup asserted that the Federal Reserve policy of interest rate rises and Quantitative Tightening (QT) was too heavy and that the recent announcement to end rate rises and QT was too late as the economy had already been affected by a slowdown. The bank expects global equities to carry on rising over the summer months, peaking in July, with the US falling into recession at the end of 2019. Wall St has in the past rallied a further 11% after a yield curve inversion and there are indicators that markets will show growth not least on the back of China’s stimulus plans.

Bank of America has also stated that it expects US equities to reach a high in Q3 or Q4 of this year before the combined pressure of corporate debt, wage costs and policy inaction from the central banks will hit market confidence. Bank of America’s economic indicator system issued a buy signal in January which has, after the reversal of the Fed’s monetary policy, proved to be accurate. Both Citigroup and Bank of America suggest rotating equity into bonds as the year moves forward. We are implementing this strategy now in this rebalance by increasing our bond holdings.

US non-financial companies have increased their corporate debt levels from US$2.5tn to US$6.5tn in the past nine years mainly to buy back stock from shareholders and therefore lift stock prices. Large numbers of corporations have credit ratings of BBB which stand in investment grade but only just above non-investment grade bond status. Any US recessionary shock could easily see these corporations’ bonds fall in status from investment grade into high-yield, non-investment grade, prompting a heavy sell-off as well as a price reduction due to lack of liquidity in the bond markets.

Another potential indicator of recession is a slowdown in labour markets as fewer jobs are created. According to the US Bureau of Labor Statistics (BLS) job creation in the US has been very strong with increases in pay role numbers by 56,000 in February, 153,000 in March, 224,000 in April, but a disappointing 75,000 in May. While May’s figures were well below the 185,000 expected, this represents a record 104 consecutive months that new jobs have been added to the US economy. Unemployment stands at 3.6% in May which is the lowest jobless rate since December 1969. These healthy numbers should go some way to dampen near term recession fears.

Consumers confidence is also an important factor. The Federal Reserve has indicated that it does not intend to raise interest rates again in 2019 so the cost of borrowing will not increase and therefore should not impact consumer spending levels. However, interest rates on credit card repayments are the highest they have been for a decade and US car finance and mortgage offers have declined. It is quite possible that consumer confidence dipped after the Q4 dip in equity markets, the impact of additional tariff costs on Chinese imports, and the general waning of Donald Trump’s December 2017 tax cuts. These concerns are easing, but if the US consumer started to tire, the global economy would feel it and follow. US consumers account for 17% of world GDP growth, more than any other single factor.

The Federal Reserve has downgraded its forecast for economic growth to 1.8% in 2019 while unemployment is predicted to stay at 3.7%. Interestingly, the minutes of the March Federal Reserve Open Markets Committee (FOMC) meeting showed that the Fed does not expect a recession in the USA in the next few years. This view was not shared by the International Monetary Fund (IMF) who feel that the global economy is vulnerable to record corporate borrowing, a Eurozone sovereign bond crisis and high debt levels in China, which is in so many ways the engine of global growth.

In May, the IHS Markit US economic momentum gauge fell to its lowest level since September 2009 as American manufacturers were hit by the fading fiscal stimulus and damaging trade disputes between US and China, Europe and Mexico. There is now evidence of US manufacturing order books declining.

Analysts are pointing to the inversion of the US treasury yield curve as a prediction of recessionary pressure and have called upon the Fed to cut interest rates early as well as ending quantitative tightening now rather than in September to improve liquidity in markets. Both these measures could avoid a downturn. Deutsche Bank is predicting an 85% chance of a US rate cut, while JP Morgan expects two rate cuts in the next six months.

Despite these calls, the May meeting of the Federal Reserve Open Markets Committee (FOMC) continued to give no indication of making an early intervention. This led to a market fall as investors had already priced in a rate cut this year. Analysts believe that the Fed does need to respond to a developing new reality sooner than later in order to stave off recession. We are now expecting the Fed to support the US economy with at least one rate cut this summer.

The Federal Reserve has downgraded its forecast for economic growth to 1.8% in 2019 while unemployment is predicted to stay at 3.7%.

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