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Has the U.S. Economy Shaken Off Recession Concerns?

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This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here

 

It never fails to impress. There are always a number of economic predictors calling out the potential for future weakness in the U.S. economy. Forecasters across the board have warned (again and again) of the potential for a U.S. recession either in 2020 or 2021. Last year’s fourth quarter stock market plunge appeared a clear sign – about what equity traders thought about the topic.

However, U.S. quarterly GDP growth rates continue to surprise on the upside. This is leading perma-bear forecasters to push the recession’s ETA further into the future.

Given the recent macro readings, how likely is it we see a U.S. recession anytime soon?

The proof is generally “in the pudding.” In our case, it is in the macro data. However, this time around, in a long, long cycle, it’s far from obvious what the direction of the U.S. economy seems to be. Given the usual economic indicators.

Zacks economists think the following factors should be closely watched. They are the most-favored indicators on the status of the current U.S. economic engine:

(1)  Fed Policy: At this year’s first FOMC meetings – in January and March – Fed officials eased off from their stance from last year – which seemed to be heading in one direction only. Namely higher interest rates.

The May 1st 2019 meeting didn’t cause a change in that “patient” viewpoint. In fact, the press release was notably brief. It did offer up a broad and foggy topic of discussion about the strengthening economic growth that has come along with continued weak readings in consumer price inflation, of various flavors...

On a 12-month basis, overall inflation and inflation for items other than food and energy have declined and are running below 2 percent. On balance, market-based measures of inflation compensation have remained low in recent months, and survey-based measures of longer-term inflation expectations are little changed.” – May 1st FOMC statement

The Fed’s preferred inflation gauge, core PCE, the price index for personal consumption expenditure only rose at +1.6% in April according the Commerce Department’s estimate.

Want our reading of the latest statement by the FOMC? The Fed is well aware of the challenges for a soft landing with any rate hike policy. Powell and Company will raise rates one more time only based on very convincing incoming macro data. That is, strong U.S. GDP growth for 2 to 3 quarters in a row; with robust and conclusive evidence of consumer inflation manifesting itself above 2.0%.

(2) Yield Curve: No analysis of U.S. recession predictors can be complete without the most notorious one: the yield-curve inversion. This plots bond yields from short-term to long-term maturities.

This is considered a prescient barometer of economic sentiment. Usually, bonds with shorter maturities tend to have lower yields compared to bonds with longer maturities, as investors typically require to be more fully compensated with higher yields for longer holding periods – given the increase in risk.

Whenever this fundamental relationship has been violated in the past, prognosticators have witnessed a recession hitting within 6 to 18 months on average.

You can see in the graph (on the next page). A yield curve inversion (shown by the blue line) is typically measured as the difference between the 10- and 2-year yield as depicted. But often, shorter 1-month to 10-year yields are also used as a comparison.

Based on this metric, we have not witnessed the inversion yet. However, other yield curve combinations have turned negative briefly this year (e.g. the yield on the 3-month bill exceeded that of multiple longer-term securities).

The reason for the latter inversion is relatively simple: the short-end tends to respond solely to FOMC policies. The long-end tends to be more receptive to bigger macro trends (such as inflation expectations, international demand for longer-termed bonds).

Then, add in the effects of “QE” bond buying. In 2019, the novelty is Targeted Long-term Refinancing Operations (TLTRO) done by the ECB. The latest hit at 4-year commercial loan tenors. You can see this in the graph below:

 

Different forces for both ends of the curve make it very difficult to argue that some underlying mechanism causes recession. Simply because of lower yields outside of the U.S., a lot of demand for long-term U.S. bonds suppress their yields.

A potential causal relationship to actual recessions in output comes from the bank-lending channel.

That is, banks borrow at the short end (paying deposit rates) and earn interest at the long end (through loans to consumers, homeowners, etc.). As the yield curve inverts, their net interest margins get squeezed. Profits fall. Banks could provide fewer loans. Economic activity can tend to slow down.

It is not necessarily evident, however, that net profit margins of banks indeed do get squeezed much by any yield curve inversion. Given that fact banks tend to not pass on higher rates to deposit accounts, and they tack on lots of charges.

Given the Fed’s “patient” pause in raising rates at the short end, a flattening of the curve should remain stagnant. The yield curve indicator needs to be watched for more strenuous signs. At the moment, it is not quite ringing the alarm bells for a recession.

(3) Leading Economic Indicators (LEI): The Federal Reserve Bank of Philadelphia compiles this index. It is based on a data from a number of reliable indicators such as state-level housing permits, state initial unemployment insurance claims, the manufacturing survey by the Institute for Supply Management, the spread between the 10-year treasury and the 3-month treasury bill, and other factors.

The graph (below) gives you a good indication of the predictive power of the LEI index in the past. Given its current level, we are still far out from a U.S. recession. However, it also is apparent. The LEI index has drifted downwards for a couple of years now. It continues to inch closer to levels below 1.0%. The LEI indicator might still recover from current levels at this point. It will be worth paying close attention to.

 

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