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Recession Watch: US Recession Odds Rekindled as Coronavirus Festers

Recession Watch: US Recession Odds Rekindled as Coronavirus Festers

2020-02-26 18:30:00
Rich Dvorak, Analyst
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Risk of Global Recession in 2020 Revitalized by Coronavirus Outbreak; US Yield Curve Inversion Deepens as Business Activity Contracts

  • Recession risk is back on the rise and largely attributable to expected economic impact from the coronavirus outbreak
  • The US Dollar has crumbled since notching a three-year high as preliminary Markit PMI data for February showed US business activity contracted to a 76-month low
  • An inverted US Treasury yield curve suggests downside risks faced by the economy still loom and could prompt the Fed to cut rates again

Odds that the US economy will soon slip into a recession are likely back on the rise. This follows our prior US Recession Watch that highlighted a downshift in recession probabilities and the US-China trade war late last year.

Now, as the coronavirus hits confidence and sends a shockwave across the global supply chain, economic data is starting to deteriorate rapidly. Chances of a global recession in 2020 have been rekindled as a result.

US Economy Starts to Crack as Services Sector Contracts Amid Coronavirus Contagion

Considering how China is the second largest economy in the world, it is expected that the hit directly to Chinese GDP will drag total trade and business activity lower across the globe in a similar fashion.

This theme was just highlighted in a study published by the World Trade Organization on how global merchandise trade growth is likely to weaken further into 2020.

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Meanwhile, American businesses have already started to sound the alarm bell. Apple Inc (AAPL) – the biggest US company by market cap – announced it sees its revenue at risk and not expected to hit its revenue guidance for the quarter owing to the coronavirus outbreak.

A gloomy Markit PMI report just revealed that US business activity – notably in the services sector – contracted during February and for the first time since October 2013.

IHS Markit PMI Historical Chart US Business Activity Services Sector Contracts February 2020

The composite output index took a tumble to 49.6 for February and is down from a reading of 53.3 the month prior. Even more worrisome than the composite PMI figure was a nosedive in the services business activity index, which fell at the fastest rate on record to a fresh 76-month low.

The latest Markit PMI report has consequently brought the overall resilience of the US economy into question as business activity contracts. At the same time, recession risk looks set to rise seeing that the services sector is a primary component of US GDP.

US Treasury Yield Curve Inversion Deepens Due to Investor Demand for Safety

Recession risk permeating across the broader market can be observed by taking a look at the US Treasury yield curve given its historical usefulness in predicting potential economic downturns.

A notable flattening of the US Treasury yield curve has occurred since traders caught wind of the novel coronavirus outbreak earlier this year, which led to the latest inversion along the three-month and ten-year maturities.

Specifically, the 3m10s and 2s10s yield curve spreads dropped from 30-bps and 34-bps respectively at the beginning of the year to the latest measurements of -0.17% and 0.16%.

Chart of US Yield Curve Inverted Recession Risk

This largely stems from the anticipated drag on global GDP growth due to the novel coronavirus outbreak, which has led investors to flee risk and seek safety provided by long-dated government bonds such as 10-year or 30-year Treasuries.

With the US Treasury yield curve inverted once again along the 3m10s curve (i.e. the three-month and 10-year maturities), market sentiment could deteriorate further as investors take notice of rising recession odds due to economic contagion from the festering coronavirus pandemic.

Coronavirus Outbreak Hampering Business Activity, Global GDP Growth & Market Sentiment

While the total economic impact caused by the novel coronavirus outbreak is yet to be determined, several preliminary datapoints and measurements of business activity paint a pessimistic picture.

China car sales during the first two-weeks of February cratered 92% year-over-year. A recent survey of sales managers at Chinese companies shows that business confidence fell off a cliff to its lowest reading on record.

Around half of the 109 US businesses polled with operations in China noted a material lack of workers due to widespread travel restrictions and quarantines mandated by the Chinese government.

The Chinese economy is only operating at about 55% of capacity according to a recent report from the Ministry of Commerce.

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Meanwhile, tourism across Asia is at a standstill judging by Hong Kong average visitor arrivals data, which crashed to under than 3,000 travelers per day and compares to last year’s figure of 200,000 per day.

In turn, Song Xiaowu, a Chinese economist and government policy advisor, stated that China may need to adjust its 2020 GDP growth target as first quarter growth could drop to 3%.

Similarly, HSBC slashed its 1Q-2020 China GDP forecast to 4.1% from 5.8% citing the coronavirus impact.

The unexpected and debilitating shockwave sent to the global supply chainwill likely have a lasting impact on business activity above all else. This fundamental backdrop typically bodes well for the USD on balance.

USD Price Analysis: US Dollar Index Ricochets Off 3-Year High Amid Rise in Fed Rate Cut Bets to Stem Coronavirus Impact & Jump in Recession Risk

USD Price Chart US Dollar Coronavirus Recession

Chart created by @RichDvorakFX with TradingView

A staggering rally in USD price action across major currency pairs since January 01 pushed the Greenback up 3.5% on balance prior to the February 21 selloff sparked by the Markit PMI contraction.

The reversal in the US Dollar off a three-year high followed a rise in Fed rate cut expectations after the disappointing Markit PMI data crossed the wires.

Perhaps the 23.6% or 38.2% Fibonacci retracement levels of the recent bullish leg will be looked toward as possible downside targets by USD bears if there is a lasting acceleration in FOMC rate cut bets.

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Overnight swaps have priced in an additional 18-basis points of Fed rate cut bets since the relatively-less dovish January 2020 FOMC minutes crossed the wires last week. Nearly two 25-bps interest rate cuts are now expected by the September 2020 Fed meeting.

This compares to the neutral monetary policy outlook according to the latest FOMC official projections, which detailed no expected change to the median target Federal funds rate estimate for this year.

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Nevertheless, the US Dollar’s near-vertical ascent during the first seven weeks of the year seems underpinned by widespread demand for safe-haven currencies, which is a facet of the forex market where USD reigns king.

Aside from vast liquidity of the US Dollar and its status as the world’s reserve currency, the American economy is and will likely remain the ‘best out of a bad bunch’ in light of overall solid consumer spending and a strong jobs market.

Upcoming nonfarm payrolls and consumer confidence reports could thus carry greater credence over USD price action, broader market sentiment and the risk of a recession going forward.

Keep Reading – Gold Forecast: Bullion Bid on Recession Risk, Inverted Yield Curve

-- Written by Rich Dvorak, Junior Analyst for DailyFX.com

Connect with @RichDvorakFX on Twitter for real-time market insight

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