US Yield Curve Inversion Talking Points:
- There is a 32% chance of a recession hitting the United States within the next 12-months – but that’s before factoring in the US-China trade war flaring again.
- But this reporting period ended on August 2, before the major plummet in US Treasury yields around the announcement of the Trump tariffs; the 3m10s spread was -8-bps; on August 7, it stood at -32.4-bps. Real-time odds are closer to 40%.
- As US recession fears rise, Fed interest rate cut expectations have soared, with three more 25-bps cuts due in 2019, according to Fed funds futures.
In the first entry in the US Recession Watch series, we concluded that “Summer 2019 is unlikely to be the typically slower trading period that the middle of the year represents. Geopolitical tensions continue to rise across the globe, and the US-China trade war has yet to make meaningful progress towards resolution. As the path forward is uncertain, traders should anticipate rising volatility in FX markets.”
Over the past four weeks, since the last iteration of this report, the possibility of the US-China trade war devolving into an outright currency war have dramatically stoked fears of a major global slowdown. Recent price action in financial markets runs counter to better economic data that was otherwise showcasing resiliency in the US economy.
US Growth Expectations Remain Soft as Data No Longer Surprises
Relative to analysts’ expectations, the US economy has been on better footing: the Citi Economic Surprise Index for the US has improved from –56.3 to -35.1 over the past four weeks. Yet the stretch of US economic data beating analysts’ expectations may be over.
Take a look at the July US jobs report, for example: the actual reading came within 1% of the estimate, something that has not happened at any other point in the past 10 years. Now that US economic data is no longer beating expectations; analysts have adjusted their mindsets and are now more accurately tracking the state of the US economy.
To this end, we may see the period of US economic data outperformance – surprising analysts’ expectations to the topside – come to an end.
Atlanta Fed GDPNow Q2’19 US GDP Estimate (August 7, 2019) (Chart 1)
A lack of potential for further upside surprises for the US economy is coming at a particularly inopportune moment. US growth expectations are already flagging despite data improving relative to analysts’ expectations in recent weeks. Based on the data received thus far about Q3’19, the Atlanta Fed GDPNow forecast is looking for growth at 1.9%. The next update to the Q3’19 forecast will be released after Thursday’s US wholesale trade report.
Fed Rate Cut Expectations Surge
So much for the US-China trade war détente after the G20 summit in Osaka, Japan. In the intervening period, but particularly since the surprise tariff announcement on August 1, Fed interest rate cut expectations have climbed rapidly – a strong sign that market participants feel that a global slowdown is coming, and policymakers will take steps to prevent it.
Prior to the July Fed meeting, Fed funds futures were discounting a 76% chance of another 25-bps rate cut in September and a 56% chance of a third and final 25-bps rate cut in December 2019.
Federal Reserve Interest Rate Expectations (August 7, 2018) (Table 1)
Now, according to Fed funds futures, after the Trump tariff announcement on August 1 and the ensuing USDCNH devaluation, there is now a 100% chance of a 25-bps rate cut in September, an 85% chance of another 25-bps rate cut in October, and a 62% chance of a 25-bps rate cut in December. Markets have dragged forward expectations of a fourth rate cut of the next 12-months to 53% chance in June 2020.
Using the US Yield Curve Inversion to Predict Recessions
The impact of the US-China trade war has been felt two-fold on the US yield curve. With Fed funds pricing in a greater likelihood of lower short-term rates, the short-end of the US yield curve has fallen. Second, with growth expectations depressed, the long-end of the US yield curve has fallen. However, this has been a non-parallel shift in the US yield curve; this “flattening” of the US yield curve is foreboding for the US economy.
US Treasury Yield Curve (August 7, 2019) (Chart 2)
A flattening yield curve typically suggests an environment of rising uncertainty over growth conditions. In context of recent news and data, it stands to reason that the US-China trade war is proving to be the driving factor behind this shift in sentiment.
Thus the key question for traders to consider over summer 2019 remains, “are the odds of a US recession rising?”
A Refresher: Why Does the US Yield Curve Inversion Matter?
The yield curve, if it’s based on AA-rated corporate bonds, German Bunds, or US Treasuries, is a reflection of the relationship between risk and time for debt at various maturities. A “normal” yield curve is one in which shorter-term debt instruments have a lower yield than longer-term debt instruments. Why? Put simply, it’s more difficult to predict events the further out into the future you go; investors need to be compenstated for this additional risk with higher yields. This relationship produces a positive sloping yield curve.
When looking at a government bond yield curve (like Bunds or Treasuries), various assessments about the state of the economy can be made at any point in time. Are short-end rates rising rapidly? This could mean that the Fed is signaling a rate hike is coming soon. Or, that there are funding concerns for the federal government. Have long-end rates dropped sharply? This could mean that growth expectations are falling. Or, it could mean that sovereign credit risk is receding. Context obviously matters.
US Treasury Yield Curves: 3m10s and 2s10s (1975 to 2019) (Chart 3)
Duke University finance professor Campbell Harvey, whose 1986 dissertation explored the concept of using the yield curve to forecast recessions, has said that the yield curve needs to invert in the 3m10s for at least one full quarter (or three months) in order to give a true predictive signal (since the 1960s, a full quarter of inversion has predicted every recession correctly). With the 3m10s spread inverted, the probability of a US recession is rising.
NY Fed Recession Probability Indicator (August 7, 2019) (Chart 4)
Using the 3m10s spread, the NY Fed Recession Probability Indicator is now suggesting a 32% chance of a recession hitting the US economy within the next 12-months.
Conclusions about US Yield Curve Inversion and Rising Recession Odds
But this reporting period ended on August 2, before the major plummet in US Treasury yields around the announcement of the Trump tariffs; the 3m10s spread was -8-bps; on August 7, it stood at -32.4-bps. Accordingly, backing out this assumption, the NY Fed Recession Probability Indicator would be pricing in greater than a 40% chance of a recession hitting the US economy in the next 12-months if the indicator were updated in real-time. What does this mean? More volatility is coming to FX markets.
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--- Written by Christopher Vecchio, CFA, Senior Currency Strategist
To contact Christopher Vecchio, e-mail at firstname.lastname@example.org
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