What lies behind the yield curve?
The so-called ‘yield-curve’ is probably the most popular market predictor for economic health. This curve is measured by subtracting current short-term government bond rates from those offered on longer-term bonds. Whilst typically this difference is positive (with long-term above short-term rates), in times of economic uncertainty it often shrinks, or even inverts entirely (i.e. becomes negative). How exactly, you may ask, is this indicator connected to the future state of the economy? This connection is provided by central banks, which manipulate short-term interest rates so as to keep unemployment and inflation at target levels. If the economy falters, the central bank will typically lower rates so as to stimulate spending and investment, and since the central bank rate operates as the benchmark for the wider economy, this inevitably drags down rates on all market assets. Thus, if an economic downturn is considered likely, investors will expect market rates to soon fall in line with monetary policy. In such a scenario, investors see higher interest rate, long-term bonds as very attractive investments: once market rates fall, they will offer superior returns to other assets. As such, investors pile into long-term bonds, which pushes down their interest rate and shrinks the difference between them and shorter-term instruments.
With that clarified, we can make sense of the rate gap between 10-year and 3-month US Treasury bonds. As shown by the figure below (courtesy of the Cleveland Fed), in January this gap narrowed to a post-crisis low of 0.35 percentage points; with the 10-year offering 2.75% and the 3-month 2.4%. For reasons discussed earlier, this flattened yield curve indicates significant market pessimism over America’s growth prospects in the year ahead. Based on these movements, the Cleveland Fed puts the probability of a recession in the US by next January at 26.5% - a marked increase from November and December of 2018. More worryingly, a broader model developed by economists at JP Morgan, which includes the yield curve as well as stock market performance and other credit spreads, predicts a 91% chance of a recession in 2019. The question is, are these predictions to be believed?
Jitters at home and abroad
To answer this, we have to look at the direction of economic policy as well as the data continually being released. As to the former, there was significant concern that the Federal Reserve would pursue overly ‘tight’ monetary policy by pushing up interest rates several times this year. With the Fed’s benchmark rate already at a post-crisis high of 2.5%, market participants fret that any further increases may make the cost of credit too dear, thus chocking off spending and depressing economic growth. Yet, at the Fed’s last meeting on January 30th, Chairman Jerome Powell signalled a more patient approach – vowing to hold off on (or even reverse) rate increases if the economy slows significantly. Thus, it seems unlikely that in the near term the Fed will induce a recession from over-tightening.
What about on the international sphere? Here there is plenty of ground for concern – notably, the Eurozone is slowing sharply. Italy fell into recession at the end of 2018 – and Germany only narrowly avoided the same fate. China’s growth in Q4 fell to a post-1990 low of 6.4% (which is albeit still a very respectable growth figure, especially for such a large economy). In light of this, it is hard to deny that the global economy is slowing – but we must ask how severely this will affect the US economy. The consensus around this seems to be ‘not very’ – that is, If the slowdown continues at its currently modest levels. This is because, the US is a very domestically oriented economy – with only 27% of its GDP in 2016 being constituted by trade – compared to 59% for the UK and an astounding 84% for Germany. Thus, the US is far more shielded from global headwinds than most other developed economies.
It’s all in the numbers
Despite the market gloom – and the fact the US government only recently emerged from a 35-day shutdown – current economic indicators are going from strength to strength. In January, the US added 304,000 jobs, almost double the 165,000 expected – making for a record 100 months in a row of job creation. Tellingly, another model developed by JP Morgan, which uses real economic indicators (as opposed to financial market data) such as car sales and unemployment, predicts only a much lower 26% chance of recession. This reflects strong underlying growth in the US economy – which is thought to have expanded by 3% in 2018 and forecast to grow by a respectable 2.3% in 2019. Such figures however, may be misleading: it could after all be that even 2.3% growth is unsustainable. Indeed, with the Fed’s measure of long-term growth at 1.8%, and its measure for the so-called ‘natural’ rate of unemployment at 4.6%, it may be very well that the US economic is ‘overshooting’ its potential, and is destined to fall back in the near future.
Reasons to be hopeful
Important to recognise however, is that the most common sign of an overheating economy is accelerating inflation: something that has been notably absent from the current expansion. Consumer prices rose at a respectable 1.9% in the year to January, and show no immediate sign of spiralling upwards. The natural rate of unemployment is notoriously hard to measure, and it could very well be that jobs can continue to be created (and thus the economy continue to grow strongly) over the next year. Furthermore, as real wage growth accelerates, we are seeing labour participation rates increase – providing another steady source of growth for the year to come. It is important to keep in mind therefore, that despite the market gloom, the real data points to many potential upsides for the US economy.