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Market Update

Mon 2019-03-25 - American yield curve predicts recession

The US 10-year yield dropped below the 3-month yield late last week. Historically, this is a fairly certain harbinger of recession. Listed below are a few remarks.

  • The time lag between an inverted yield curve and the moment when the recession starts tends to vary between several quarters and approximately two years. The average timespan is around 1.5 years. During that period, growth will decline although this does not necessarily happen rapidly.
     

  • Whether this pattern needs to be taken with a pinch of salt is an open question. Let us not forget that the central banks' massive bond purchases have greatly derailed bond market pricing in recent years. Nevertheless, most economists are paying heed to the signal sent by the yield curve.
     

US yield
 

The growth slowdown over the past quarter, both in the US and elsewhere, is the main reason why the 10-year yield has fallen below the 3-month yield. In turn, the key causes of the slowdown were the trade war, Brexit, the US government shutdown, disappointing growth in China, and sharp share price drops. Also relevant is that the Fed has been increasing interest rates for a few years and that it has been signalling it would continue until recently. On top of this, the effect of the federal administration's fiscal impulse has started to ebb. Admittedly, most of these factors have been developing in a positive direction so far or, at least, they do not appear to be escalating any longer (see also our recent reports). But there is another issue that worries the markets.

Indisputably, debts are sky high around the world. As a result, the global economy is very exposed to shocks of whatever kind. It could be said that the growth slowdown of the past period is such a shock. Particularly in combination with the aforementioned underlying negative developments. The high debts are also adding to the shock while one of its effects is low inflation on an ongoing basis. Owing to this state of affairs we might conclude, in hindsight, that the Fed has hiked its rate too much under the prevailing conditions and that the ECB has prematurely ended its bond-buying programme. Possibly, this is more important to the economy than the fact that the aforementioned negative developments are improving (albeit not to a spectacular extent). For instance, the trade war may continue for another while although it is unlikely to escalate much further. Also, whereas a no deal Brexit seems unlikely, it remains to be seen if the alternative will be much better.

Whether or not a recession will actually occur depends on the following:

  • Central banks prefer to boost the economy too much rather than too little. As they face recession risks, they will want to act fast at the present juncture. However, the problem is that the ECB and the Bank of Japan barely have any room left to further open the money taps. Although this applies to a much lesser extent to the Fed, all central banks face the problem that they will use up virtually all of their remaining reserves if they need to respond rapidly. This could really unnerve the financial markets. After all, what is going to happen if yet another shock occurs? There is a high chance that most central banks will remain fairly reticent when it comes to further monetary easing. Whether the situation will improve much if they deploy their last reserves is very doubtful. Of course, the economy would be provided with an impulse but the dent to confidence in the future may well overshadow the latter. This implies that central banks – including the Fed – will likely only really swing into action when they have run out of options. A situation that will likely arise once share prices are plunging.
     

  • Another way out is to boost economic growth through much larger budget deficits but the same applies here as to monetary policies. There are so many objections to much wider deficits that this will likely only happen in an emergency situation.

Conclusion

Whether or not the economy will end up in recession and – should that be the case – to what extent, will strongly depend on how fast and forcefully monetary and fiscal action will be taken. It is impossible to predict this at the present juncture. We think action will only be considered after the situation has worsened. The main indicators will be lower share prices and higher credit spreads, which will likely be on the cards unless the economic data starts to improve. In any case, the markets are currently signalling that they do not believe this will happen any time soon so the following should be seriously taken into account:

  • Credit spreads can significantly widen and share prices may fall in the coming period
     

  • We could see persistent downward pressure on interest rates until far more monetary and/or fiscal action is taken
     

  • EUR/USD can fall as the European economy faces less positive prospects than the US economy under these conditions

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