Background to the market: Does the yield curve predict recession?
There’s a lot of talk nowadays about the yield curve. It reminds me of the good ol’ days of the bond vigilantes and the talk about how the bond market “can intimidate everybody.” At the moment, the question is whether the bond vigilantes will intimidate the Fed and stop it from hiking, or at least convince it to pause.
Looking at the short end of the yield curve, the Fed funds to 2yr curve inverts a lot. That doesn’t give much of a signal. But the 2yr/5yr curve has inverted before every recession since 1980, and it hasn’t given any false signals, either. Right now it’s modestly inverted – by about 1 bp. Note though that it usually starts to invert well before the recession begins, and in fact sometimes disinverts before the recession starts – for example, looking at the 1990 recession, it went negative in December 1988, it was at its most inverted in March 1989 and was positive by January 1990, whereas the recession didn’t officially start until July 1990, 19 months after the inversion began. Similarly, it went negative in March 2000 but turned positive again by January of the next year; the recession started two months later.
It’s a similar story with the longer-dated curves. Yes, the curve does seem to invert before a recession, but by no means immediately before a recession – and in most cases, it has disinverted by the time the recession began.
With this kind of history in mind, the market has significantly pared back its expectation of Fed tightening. Since the November FOMC meeting, expectations of three more hikes by the end of 2019 – one in December and two next year – have collapsed. That scenario is now seen as almost as probable as no more hikes at all! The betting is now on just one more hike before the end of 2019 – maybe a hike in December, then nothing next year.
This change in Fed expectations is bound to weigh on the dollar. The steady rise in US rates has been one of the main factors bolstering the US currency over the last several years. If that is seen to be coming to a halt while other countries are tightening their policy, however gradually, then the US rate advantage will diminish and the dollar will be likely to decline.
Personally, I think the market is being overly pessimistic. I think the yield curve may not be as reliable an indicator as in previous years because the short end has been distorted by the extraordinary monetary policy of the Fed for years now. Furthermore, the inflation dynamics are different than they were before, meaning the behavior of the long end of the curve isn’t what it used to be.
Finally, other indicators suggest the US is nowhere near recession. In particular, the Institute of Supply Management (ISM) manufacturing purchasing managers’ index (PMI) is still quite high, indicating continued expansion. While there were cases in the 60s and 70s where the index plunged as the recession started, in more recent years it’s declined notably well before the recession began. So far, no signs of that happening in the near future. I think investors may be confused by looking at a gauge that’s distorted by the lingering impact of the Fed’s extraordinary monetary policy and could be underestimating the resilience of the US economy – and the dollar.
Week ahead: Brexit vote, EC/EU summit, ECB meeting, US CPI, Tankan
Usually the second week of the month is quiet, and often December is a relatively quiet month as people wind down their activities, go to Christmas parties and get ready for the holidays. Not this year! This coming week is one of the more action-packed weeks I can remember in a long time.
Heading the list of coming attractions is Tuesday’s vote in the UK Parliament on the EU Withdrawal bill. The Government seems likely to lose it. If it does, the situation is quite complex. I’ll let you take a look at this flowchart from Morgan Stanley Research to see the possible outcomes.
I would point out that if a second referendum is held, there will be a chance that they don’t leave the EU at all – that would send GBP soaring. On the other hand, if there are early elections and Labour gets into power, Labour + Brexit = doomsday scenario for GBP – I’ll finally get the GBP/USD Parity Party I’ve been waiting for since 1984! Or at least a EUR/GBP Parity Party. In any case, the Bank of England estimates that in the case of a disorderly exit, the pound could fall 15%-25%.
If they vote the measure down, then there could be a leadership challenge in the Conservative Party and a vote of “no confidence” in Parliament on Wednesday or Thursday.
Against this background, the important UK data coming out during the week – trade, industrial production and monthly GDP figures on Monday, employment data on Tuesday – are really small beer. We saw during this week how a shocking service-sector PMI had no impact in the face of Brexit news.
There will be an European Commission and EU Summit meeting Thursday and Friday. I assume Brexit will be on the agenda, as always. Assuming the Brexit bill doesn’t pass on Tuesday, I would assume the EU would reiterate that “there is no alternative,” as Mrs. Thatcher used to say, and that would just raise fears of a “hard Brexit” = GBP-negative. Of further interest to the market will be discussion on measures to boost the international use of the euro. The most dramatic of these is a recommendation to encourage the use of the euro in settling oil and other energy import bills. The EU is the largest energy importer in the world, with its external energy bill amounting to some EUR 300bn a year. If that shifts away from dollars, it could reduce overall demand for dollars and cause the dollar to weaken over the longer term.
The other main point during the week will be the ECB meeting on Thursday. They’ve pledged not to change their rates until next summer at the earliest, so that’s not on the schedule – the main question is whether they’ll end their monthly bond purchases, thus bringing to an end the global monetary experiment with quantitative easing (QE). I think most people assume that they will, but nothing is 100% certain in life. If they do decide to extend it further, that would be a shock to the market and probably result in a substantial fall in EUR.
Of course, QE has both flow effects and stock effects; just because they end the flow of purchases, the fact that they continue to hold such a huge stock of bonds will continue to offer some monetary stimulus. One focus of attention will be any hints on when they might begin to roll off their maturing bonds.
With the bond purchases scheduled to end and rates not yet scheduled to rise, the focus will then be on the updated ECB staff forecasts, including for the first time forecasts for 2021. Normally the staff forecasts aren’t that different from the market consensus. Given the slowdown in the German economy, fall in oil prices, trade tensions etc., we could see a downgrade of the staff forecasts. That could be negative for EUR. In that context, we could also see a change in the line in the ECB statement where it says that the risks to growth “can still be assessed as probably balanced.” If they decided the balance of risks was on the downside, that would imply a longer delay before tightening rates and would also be negative for the currency.
The Swiss National Bank (SNB) meets a few hours before the ECB does, but they aren’t going anywhere until well after the ECB changes its stance, so that meeting isn’t likely to garner much attention. The SNB wants to see EUR/CHF back up at 1.20, but it’s not obliging.
The main indicator of the week is the US CPI, out on Wednesday. The CPI isn’t the inflation gauge that the Fed actually targets –that’s the personal consumption expenditure (PCE) deflator, or more accurately, the core PEC deflator – but the market pays attention to it almost as if it were. Surprisingly, the market pays more attention to the headline CPI figure than to the core figure, whereas with the PCE deflator the attention is definitely on the core figure. With the unemployment rate deeply into what the Fed considered “full employment,” any questions about the pace of tightening are tied to the inflation side of their dual mandate, so this is a key indicator for the markets. This month, both the headline and core are expected to be up 2.2% yoy, both still above the Fed’s 2% inflation target, so this should be bullish for the dollar.
On Friday morning in Tokyo, the Bank of Japan announces its fourth-quarter short-term survey of economic conditions, or tankan. This is probably the most important indicator that comes out of Japan nowadays. The large manufacturers’ diffusion index (DI) is expected to decline, as one would expect following a quarter when the economy contracted. The large non-manufacturers’ DI, too. But the small (one point) decline expected in both of them is relatively minor and they remain firmly in expansionary territory. Given everything else going on in the world today, I doubt if a small movement like this will have much impact on USD/JPY.
Elsewhere, we get a full array of indicators from China this week – inflation data on Sunday and retail sales, industrial production and fixed asset investment on Friday. The producer price index is expected to decelerate notably, which will reduce the inflationary impulse around the world. Industrial production is forecast to rise at the same yoy pace as in the previous month, suggesting that the trade war and tariffs aren’t having that much of an impact on China – yet. It may well be however that this is due to importers ramping up orders before the tariffs come into effect and IP will slow sharply if the full panoply of tariffs is ever deployed.
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