U.S. Outlook: The Recession Countdown Clock is Ticking
The yield of the 10-year U.S. Treasury fell below that of the 2-year note this week, a strong bond market signal that the U.S. recession countdown clock is ticking. However, you probably have some time to run a few more plays before time expires.
There were hyperbolic headlines in the news media about an impending U.S. recession this week.
Stocks had their worse selloff in a year and investors fled into perceived safe havens, ranging from long-term U.S. Treasury bonds, gold, and cash.
In reality, we will need to see a deeper and more prolonged 2-10-year spread inversion before it would be a truly reliable recession signal. In past cycles, the 2-10-year spread has inverted by an average of 40 basis points for 13 consecutive months before a recession has occurred. One day of inversion by two basis points doesn’t cut it.
We share the markets’ widespread concerns about slowing U.S. and global economic growth and recognize the risk of recession in the U.S. in the coming year is elevated. I was one of the earliest economists on Wall Street to actually forecast it. However, Thursday’s robust July retail sales report reminds us that a U.S. economic recession, if it is coming, is probably not imminent. Our economic and financial fate for 2020 is not yet sealed.Central Banks Play Catch Up
Many of the fears driving bond yields lower and daily stock market volatility higher are being driven by perceived economic policy failures. The U.S.-China trade war escalation and the heightened level of uncertainty this creates for consumers and businesses is the primary suspect. However, growing concern that the Federal Reserve and other global central banks may be behind the curve in responding to the slowdown is another area that deserves honorable mention.
Economic troubles from abroad were already percolating in early 2018 before the U.S.-China trade war really escalated. Around the same time, the Fed put quarterly interest rate hikes on autopilot. At the time, we argued the combination of accelerated interest rate hikes and balance sheet shrinkage might be too much monetary tightening, too soon. We started forecasting a U.S. economic slowdown for 2019 and below-trend growth for 2020 well before most saw it coming.
I am not optimistic that we will reach a comprehensive trade agreement with China before the U.S. election next year. Furthermore, the prospect of additional fiscal stimulus is equally unlikely. That leaves the Federal Reserve to shoulder the burden of sustaining this economic expansion for as long as they can.What the Bond Market is Really Saying
Yield spreads invert when investors think interest rates in the future are going to be lower. Since 1976, the 2-10-year spread has inverted every time before a recession, with an average lead time of 15 months and a median lead time of 16 months. The only false warning was a modest 2 basis point inversion in June 1998 that was reversed a month later.
Of course, history is an imperfect guide and the Treasury yield curve should not be the only indicator by which you run your monetary policy, business, or make important investment decisions. Indeed, there is a unique factor that needs to be considered. There is a record $16 trillion worth of sovereign bonds trading with negative nominal yields today.
With a 10-year Treasury yield of 1.5% and a strengthening dollar, U.S. Treasury bonds are an attractive investment for foreign investors. This flood of global capital could be exaggerating the recession signal that the 2-10-year spread is giving us today. If not imminent recession, the signal that U.S. and global bond markets are reliably sending to us today is to expect much slower growth ahead, and—by the way—get used to very low and for some countries even negative interest rates. They might be here for a long time.
For more, see my full U.S. Outlook, delivered on August 16.