Given the first sign of stress, economic commentators love talking about the doom and gloom scenario. The nine-year bull market that has been in place since the worst economic crisis in modern history has divided opinion, and with many nations worse off in real terms since 2007, it doesn’t take much for concern to re-emerge.
The markets this week witnessed a key indicator that we could be heading for a period of economic downturn, as the yields on US treasuries between the 3-year and 5-year section of the curve inverted. This means that investors are seeking a higher percentage compensation for holding shorter dated debt, or conversely that the market perceives the US Government less likely to repay debt in three years’ time than in five years. The spread between 2-year and 10-year treasury yields, a more liquid area of the curve, also fell to a pre-crisis 2007 low of 10bps and has itself inverted after every 3’s-5’s inversion. The aggressive bull flattening of the US yield curve to the point of inversion has been followed after approximately 620 days by a recession in every instance since the 1970’s.
If we do a quick health check, we see that the US economy is far outperforming fellow peers, which has resulted in a diverge of monetary policy across the major economies. Japan’s GDP growth rate is forecast to stutter to 1.1% on the year, a climbdown from 1.7% in 2017, and has experienced two quarterly recessionary periods of -0.3% this year. Inflation also remains benign, forcing the Bank of Japan to consider further accommodative monetary stimulus despite Governor Kuroda’s March 2018 signal that they may look to normalise policy from April 2019. After a 2.3% GDP boost in 2017, Eurozone growth has decelerated in 2018 from 0.4% growth in Q1 and Q2, to a four year low of 0.2% in Q3. Bond market behaviour in the nineteen-country bloc is not filling investors with much confidence either, as yields on the 10-year German Bund (An effective risk-free Euro debt barometer) fell to a twenty-month low of 0.24%. This is despite having already priced in current geo-political risks and the knowledge that the European Central Bank will terminate its existing bond buying programme in December. Concerns about global demand stemming from diminishing economic sentiment, coupled with geopolitical concerns, trade wars, off-setting business cycle-fiscal stimulus are driving thirst for long-dated ‘safe haven’ debt, and reducing demand for risk. As demand for this long-dated debt increases, prices increase, and yields decrease. At the short end, yields are being increased in the US by the Fed’s open market operations. If we know that a yield inversion will likely end in a recession, why not act to prevent one?
The Federal Reserve may have tried, although these efforts could potentially have been made too late. Last week, ‘dovish’ comments from key Federal Open Market Committee members triggered a sharp reversal in the market implied probability of further interest rate hikes, down to one from three next year. Fed Chair Jerome Powell has recently started citing that the delayed impact of rate hikes could be a key headwind for future economic health, as rate hikes typically impact the real economy on a lag anywhere from three months to two years. Historically this has been problematic; monetary policy has remained ‘tight’ in the past despite such warning indicators, ultimately resulting in recession. The FOMC have also signalled that future decisions on key rates will be derived more from observable data readings, thus shifting towards a ‘wait and see’ passive shorter-term position rather than the longer term forecasted trajectories ‘The Street’ has been accustomed too.
Employment data remains strong, but for how long?
The timing of such a position change is positive and gives the Fed room to manoeuvre in the months ahead. Labour conditions remain their tightest in 49-years, with annual wage inflation at 3.1% year-on-year, the highest rate since 2009, however recent non-farm payroll data stumbled somewhat. In the month of November, the US economy added 155,000 jobs versus 198,000 expected, coupled with downward revisions to previous month first readings. Moody’s Analytics, the producer of the ADP jobs report that is released the Tuesday prior to non-farm payroll data, announced that ‘jobs growth has likely peaked’, whilst big US companies including General Motors and Ford recently announced job cuts coming in the year ahead as part of operational strategy. The November jobs reading was also artificially boosted by an increase of holiday season temporary positions, furthermore, the U6 measure of underemployment ticked up to 7.6% for the second consecutive month, and the economic participation rate remained flat.
The gap between core and headline inflation could be about to widen.
PCE inflation, the Fed’s second key area of focus, has been close to or at target since April, bolstered by tax cuts and increased fiscal spending from the Trump administration. The core measure is expected to uptick from 1.9% in 2018 to 2.1% next year, thanks to extra input costs related with trade tariffs being passed onto the consumer. Offsetting this will be October’s -30% oil price plunge that could bring the headline reading back to multi-year lows. The spread between 10-year Treasury Inflation Protected Securities and 10-year treasuries, a gauge of inflation expectations, fell to 1.908% on Thursday, the tightest spread since December 2017. The similar spread in the 5-year area of the curve has fallen from 2% in October to 1.72%, prophesying that investors are lowering inflation forecasts.
It is time to put lower rates back on the table in the short term.
The shift to a data-dependent view offers a brilliant opportunity for the Fed to revise their 2019 dot plot, which currently has three hikes priced in for 2019. A 25bps rate hike is expected to be announced at the next FOMC meeting on the 18–19th December, and this should certainly go ahead despite the key risks, to avoid exacerbating current ‘risk off’ sentiment and causing widespread panic. The Fed should use this December meeting to reinforce the new mantra that future decisions will be data driven and to carefully prepare the market for greater versatility in the year ahead. Key factors to watch include if we see a dip in retail sales over the traditionally busy festive period, inflation sharply declining by February/March 2019 and a continued trend of weakening labour market numbers in the first quarter of 2019 that suggests the November payroll figures weren’t a blip. If these factors are realised, then the Fed should be prepared to target a yield decrease in the short end of the curve by loosening key rates that will help to steepen the curve. A rate cut should not be out of the question for 2019, if historical economic mistakes are not to be repeated.