Is the US yield curve hinting at a recession?

  • India Infoline News Service
  • 07 Jul , 2022
  • 10:12 AM
An inversion of the yield curve was last seen ahead of the COVID pandemic which devastated the world economy in 2020. What is special about 2022 is that the US yield curve flashed a recession signal in April 2022 and has now followed it up with another yield curve inversion in July 2022. We will come back to the connection between an inverted yield curve and recession in greater detail later, but to begin with let us restrict ourselves to the real GDP growth projections.

Data Source: GDPNow by Atlanta Fed

The graphic above depicts the quarterly real GDP growth over the last 3 years presented on an annualized basis. Normally, a recession is defined as two successive quarters of negative growth. For the first quarter ended March 2022, the US economy contracted by -1.6%. The final data for the June 2022 second quarter is yet to be announced so we have used the most reliable projection of US GDP growth, which is the GDPNow that is tracked real time by the Atlanta Fed.

What stands out in the above chart is not just that the real GDP in the US is projected to contract at -2.1% in the June 2022 quarter. Just last month, the GDPNow estimate had pegged the second quarter real GDP estimate at -1% and in just a few days, the estimates have deteriorated by a full 110 basis points. Unlike many of the other measures, the GDPNow is a pure mathematical measure and does not have any economist discretion. That means; in the last one month, there has been a palpable and identifiable worsening of the high frequency macro growth data.

Why recession in the US now?

The recession warnings are nothing new. The first warnings came about 2 months back when former treasury secretary, Larry Summers cautioned that too much hawkishness by the Fed could eventually translate into recession. That was eventually borne out by the first quarter data and now even the Atlanta Fed projections for the second quarter ended June 2022 are hinting at a full-fledged recession with 2 successive quarters of negative real GDP growth. However, Fed continues to be unrelenting on inflation control, notwithstanding unfavourable growth outcomes.

In its latest policy statement in June 2022 and subsequent pronouncements, Jerome Powell made it crystal clear that the US Fed would not compromise on inflation. Consumer inflation has been consistently above 8% in the US with pressure on food, fuel and core inflation. According to the US Fed, the only option in front of the US Federal Reserve was to pay a price in the form of GDP slowdown to arrest consumer inflation, which is seen as patently unjust. One outcome of aggressive rate hikes has been the inversion of the yield curve.

US Yield curve inverts for the second time in 3 months

It was only in April 2022 that the US yield curve had inverted after 2 years. That has been followed by another inversion in July 2022, as shown in the graph below.

Chart Source: Reuters

The above yield spread curve is the difference in yield between the 10-year yield and the 2-year yield. Logically, you must earn more on a 10-year bond than on a 2-year bond since the tenure risk is higher. However, when there are expectations of a recession, there is uncertainty about the future and nobody wants to invest for the long term. This makes the 2-year bonds more popular than the 10-year bonds leading to a spike in the 2-year bond yields. This results in negative spread creating a negative yield curve.

A positive spread (steepening curve) typically signals expectations for stronger economic activity, higher inflation and higher interest rates. A flattening or an inversion in the yield curve means investors expect near-term rate hikes but as a result are pessimistic about economic growth in the long run. That is the picture that the yield spread curve is depicting at this point of time. This is popularly called the (2/10) yield spread and is one of the most popular measures of yield curve inversion.

Is inverting yield curve a reliable indicator of recession?

During the current week, the yields on 2-year Treasuries spiked to 2.95%, while the 10-year yields stood at 2.94% created yield curve inversion. Earlier, the yield curve had inverted in April 2022 and before that it had inverted in late 2019 ahead of the COVID pandemic. Investors are getting sceptical about the Fed’s ability to control inflation without hurting growth. The market perception is that “Soft Landing” aspired by Jerome Powell is illusory.

Is this a really reliable measure. If you look at the last 6 decades, then the US curve inverted before each recession since 1955. Normally, a recession follows the yield curve inversion with a gap of 6 months to 24 months. If you look back since the year 1900, there have been 28 occasions when the (2/10) yield curve spread went into negative. On 22 out of these 28 occasions, there was a recession. In short, the yield curve inversion indicator does look real with a strong possibility of a recession as growth falters amidst stringent inflation control.

Takeaways for the Indian economy from US recession

There are several takeaways for the Indian economy from the US yield curve experience.

·         A US recession would mean compression in demand from the US, not a good feeling since India runs the largest merchandise trade surplus with the US.

·         Several knowledge based sectors like IT, pharma, healthcare, auto ancillaries and green technologies are heavily dependent on US outsourcing orders to keep the turnstiles ticking. A recession would surely dent US spending, including tech spending.

·         More importantly, it is a signal to the Indian central bank (RBI) that an ultra-hawkish approach to inflation control may not always be the answer. With a $9 trillion bond book, there is not much that the US central banks can really do to boost economic growth from here. India must keep its options open.

For now, the Fed is wedded to the idea of 2% inflation target. Preliminary data suggests that this obsession with inflation control has already translated into recession expectations. It remains to be seen if it also actually translates into recession. At least, economic history of the United States is not on the side of the Fed.
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Will the US economy actually dip into a Recession?

  • India Infoline News Service
  • 06 May , 2022
  • 10:06 AM
In the aftermath of the 50 bps rate by the US Fed on 04th May, there is a popular joke doing the rounds in markets. What is the similarity between Jerome Powell and a gymnast? The answer is; both will realize that soft landing is the hardest part of the job. In a lighter vein, this captures the reality that only the easier task of raising rates and talking hawkish has been accomplished by the Fed. Now, comes the tougher task of ensuring the US economy does not dip into a recession (2 consecutive quarters of negative growth).

Fed starts on an aggressive note, but is it too aggressive?

When the May-22 FOMC meet started, the Fed had a single point agenda. Inflation had to be curbed quickly by raising rates and making money dearer. Fed not only raised rates by 50 bps in May-22, but also gave a clear signal that rates would go up by another 175-200 bps by end of 2022 to a level of 2.75%-3.00%.
Chart Source: CME Fedwatch
Fed will certainly hike rates rapidly. If one looks at the dot plot chart above, there is a clear indication that rates would be closer to 3% by the end of 2022. In addition, Fed will amplify the impact of the rate hikes by tightening liquidity. Effective Jun-22, the Fed will start monthly unwinding of $47.50 billion of bonds (treasuries and MBS), scaled up to $95 billion by Sep-22. It is this double whammy that markets are really worried about.

History may be against the US Fed optimism on Soft Landing

If one reads the fine print of the Fed statement, there is a lot of optimism that is implicit in it. The Fed believes that it would be able to achieve a soft landing of the US economy despite raising interest rates. That means, a spike in interest rates would curb the rate of inflation (like in the Volcker era) but growth impact would be limited. Fed expects its actions to result in inflation receding to under 3% and unemployment remaining under 4% by 2023.

Former US Treasury Secretary, Larry Summers, feels this expectation is impractical. If the Fed expects a soft landing, then history is against such a perception. Summers suggests that a soft landing of the US economy with this kind of hawkishness is not only difficult, but improbable. He sees a full-fledged recession in the US economy in the foreseeable future. Here is what the empirical data on the subject shows.

Larry Summers and Alex Domash of the Harvard Kennedy School opine that high inflation and low unemployment are strong lead predictors of future recessions. If one looks at empirical data since 1950, almost each time inflation exceeded 4% and unemployment fell below 5%, the US economy invariably went into recession within 2 years. Like the inverted yield curve, this combination of high inflation and low unemployment predicts recessions accurately.

Why will the inflation - unemployment combination trigger recession?

If we go by the projections of Larry Summers and Alex Domash, currently, US inflation is at 8.5% while unemployment stands at 3.6%. In these conditions, if the Fed adopts a harshly hawkish approach, then a recession will be hard to avert. Soft landing, may still be a far-fetched expectation. The question is; what is this link between inflation-unemployment combination and an impending recession?

Here is the explanation! Typically, inflation is an outcome of too much demand chasing limited supply of goods. That is the situation now. The Fed is trying to kill demand by raising rates to prohibitive levels. There are 3 problems that the Fed could face.

a) The consensus view is that inflation should have been controlled when it crossed 3%, not when it has crossed 8.5%. Due to its post-COVID overhang, the Fed delayed rate hikes. At 3-4% inflation, soft landing may have still been possible.

b) An important aspect is the unemployment levels at 3.6%. That means demand for labour is sharply higher than supply and that has led to higher wages. That means, even amidst higher rates caused by the Fed, demand could still remain strong for longer, and well in excess of supply. This may delay the fall in inflation and force more aggression.

c) This could get compounded by the fact that high rates of interest would seriously curb investments, which means supply would still struggle to catch up with demand. Summers and Domash apprehend that the net effect of all these factors could be a sudden collapse in demand, output and jobs, triggering a serious recession.

The moral of the story is that if the Fed sticks to its hawkish course, then a hard landing may be tough to prevent.

Rate hikes and soft landings – The American experience

If you look back at the US economy since the start of the 20th century, there have been only a handful of occasions where a spike in rates did not result in a recession. The two most recent cases are in 1984 and later in 1994. In both these cases, the Fed went for aggressive rate hikes, but it did not result in a recession. However, that misses the point that the macro situation in these two years was very different from what it is today?

In both the years, rate of unemployment was much higher and the rate of inflation was much lower than what it is today. Today, the problem is the combination of 8.5% inflation and 3.6% unemployment. As has been reiterated time and again, labour conditions in the US have never been so tight and companies are being forced to raise wages just to attract workers. Wage growth today stands at 6.6% in the US.

Does this have implications for Indian economy?

Obviously, any US recession will not be an isolated phenomenon. It will impact sectors like IT, pharma and auto ancillaries in a big way. The US remains India’s largest trading partner and a US recession means weaker demand for Indian goods abroad. Above all, if the US slows down, there would be a slowdown in active and passive fund flows into Indian markets. That is not good news for a market reliant on global liquidity in a big way.

The bottom line is that there is a high probability of the US economy dipping into recession. Even with a proactive policy approach, India cannot avoid the impact. Of course, for an inward looking economy like India, the impact would be, hopefully, much smaller.

How is the US economy adjusting to macro shifts?

  • 11 Feb , 2023
  • 11:17 AM
  • One of the big fears in the global market has been whether rate hikes would eventually translate into an economic slowdown in the US and in other advanced European markets.

The US has been hiking rates since March 2022 and has since hiked rates by 450 basis points in the last 11 months. One of the big fears in the global market has been whether this would eventually translate into an economic slowdown in the US and in other advanced European markets. The US GDP data has actually shown a positive turnaround after negative GDP growth in the first two quarters of 2022. 

However, the lag effect on growth is expected to growth towards the end of 2023. For now, the US Fed is obsessed with getting inflation back to 2% and has almost refused to relent with its hawkish policy till then. However, in a recent speech, Christopher Waller, a member of the Federal Reserve Board of Governors has sought to dispel the notion that growth would be hit. In fact, Waller has gone to great lengths to underline that the US economy was adjusting quite well to macro shifts.

What Governor Waller said about the US macro adjustment

Christopher Waller had been one of the early proponents of the hawkish theory to curb inflation, even at the cost of growth. That is a theory that even the Fed chief, Jerome Powell, has been subscribing to in the last one year. However, one macro concerns arise from the fact that the yield curve has turned negative. A negative yield curve shows uncertainty over the long term and preference for the short term; a classic lead indicator of recession. Here are some of the key points that Governor Waller made in his recent speech.

  1. Waller underlined that the US economy was adjusting fairly well to the higher interest rates triggered in the US to rein in inflation. At a policy level, Waller underlined that while growth was impacted in 2022, inflation continued to remain elevated. That made a case for the Fed to retain its hawkish stance, at least till the end of 2023.

  2. One of the main reasons why the Fed was likely to continue with the hawkish policy was the stronger than expected labour data. The US economy had created 11 million jobs in the last two years and the unemployment had fallen to a low of 3.4%. As a result, the higher interest rates were not immediately translating into lower inflation since the strong labour data was creating a demand slack in the US economy. With this inflation stance of the Fed, the question is about its impact on GDP growth of the US economy.

  3. But, even before getting to the growth story, there are some positive vibes form the US economy on the inflation front. For instance, there has been a normalization of spending on groceries in 2022, compared to the COVID years of 2020 and 2021. That is the first sign that the demand driven inflation in consumer goods could be on the way down. Waller is of the view that while strong labour data may make inflation control slower, it is a positive trigger for growth, since it shows companies can afford higher wages.

  4. Waller acknowledged that higher interest rates did pose a challenge for farmers and ranchers who borrow to smooth out the costs and returns from agriculture over the year. As Waller summed up the inflation intent of the Fed; their first job was to get high inflation off the front pages, and back to being something that households and businesses don't think too much about when making decisions. That would make it possible to address the growth issue more easily. After all, unemployment at 3.4% is the lowest level since 1951 and indicates that while inflation transmission may take longer, it was unlikely to impact growth in any serious way.

  5. On the growth front, Waller underlined that the problem of the US economy was not nominal growth, but real growth. Now, real growth is a function of inflation, so as inflation trends lower, the real growth is automatically higher. Typically, the monetary policy works with a lag. For instance, the Federal Reserve started raising interest rates in March 2022, but inflation peaked in the middle of 2022. Since then, inflation has been falling consistently, directly translating into higher real GDP growth. 

  6. Waller has suggested the need to focus less on headline inflation and more on core inflation. Now, core inflation is the residual inflation after stripping out food and energy prices. Since food and energy prices tend to be volatile, they are too vulnerable to the base effect. Hence, they may not always provide a good signal of how inflation could evolve over time. The good news is that core inflation in the US never rose as much as headline inflation since it was food and energy that provided all the volatility. 

In this background, is there reason for the Fed to be paranoid about negative growth in the US economy. The Fed has consistently underlined, and Waller has also reiterated the fact, that much of the problems were with real growth and not with nominal growth. Hence, the real villain of the piece was inflation and not growth per se. The solid labour data has been largely indicative, not only of the slack in inflation transmission, but also of the underlying spending capacity of American corporates. That is good news.

The moral of the story, as emerging from Waller’s address, is that real growth may be more of an outcome than a trigger. Strong labour data suggests that nominal growth is still robust. To boost real GDP growth, Fed needs to bring down inflation and for that they need to bring down inflation expectations. That is only possible through consistent hawkishness.


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  • 06 May, 2022 |
  • 8:20 AM

Now, comes the tougher task of ensuring the US economy does not dip into a recession (2 consecutive quarters of negative growth).

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