Is the US at risk of recession; and what it means for rate cuts?

6 Aug 2024 , 11:25 AM

HOW REAL IS THE RECESSION THREAT FOR THE US ECONOMY?

In the last few days, the global markets have gone into a tailspin. It is not just the Nifty and the Dow Jones Index; but indices ranging from Nikkei of Japan to KOSPI of Korea to the Nifty and Sensex in India have cracked vertically in the first few days of August 2024. The immediate reaction from enthusiastic market analysts in India is the unwinding of the Japanese Yen Carry trade. While that may be the ostensible reason, the root cause still lies in the wild west. But, first a word on the unwinding of the Yen Carry trade. For long, traders have preferred to borrow in Yen and deploy the funds in other countries. That was a simple way to do things as Japan had one of the lowest rates of interest and a relatively stable currency. It was almost like the low hanging fruit. However, after the recent rate hike by the Bank of Japan. On July 31, 2024, Japan hiked its interest rates sharply from -0.1% to +0.25%.

It was not just the quantum of hike, but the Japanese central bank (Bank of Japan) expressing confidence in the strength of the economy recovery. The governor of the Bank of Japan, Kazuo Ueda, has made a rather bold statement that now even 0.50% may not be a rate barrier for the BOJ. In addition, to rate hikes, the BOJ also plans to cut its market support (bond buying) program by nearly half. The tightened liquidity and higher rates had an immediate impact, hardening the Yen against global currencies. For an export-driven economy like Japan, a strong Yen is bad news, so obviously the markets cracked. However, the crux of the problem was in the fears that the US economy was slowing and was almost on the brink of recession. There is no official indication to it, but markets are confident that the US would slip into recession. While the GDP growth in the second quarter has been much stronger than Q1, and the US yield curve is yet to slip into negative spreads, the latest labour data for July 2024 shows clear signs of a likely slowdown in the US. Here is a dekko.

JULY 2024 LABOUR DATA PAINTS A GRIM PICTURE

Normally, when the labour data is announced each month, there are some factors that are out of line, but the broad theme was always that the US economy was not too far from full employment, which is defined as 3.5% joblessness. The sentiments changed when the labour data released by the US Bureau of Labour Statistics for July 2024 came in worse than expected. At 4.3%, the rate of unemployment in the US was 20 bps higher than the previous reading in June. More importantly, the level of 4.3% unemployment in the US is the highest level recorded since October 2021, when the unemployment rate had touched 4.5%. However, before we go ahead, there is an interesting dichotomy we need to apprehend.

The US Federal Reserve (US central bank) has the twin objectives in its monetary policy viz. maintaining price stability and ensuring maximum employment. In short, price stability had to be achieved without endangering the labour market and jobs situation. Now comes the big dichotomy. The level of unemployment at 3.5% is normally defined in the US as full employment. It has been in that region and even below that level for a better part of 2022 and 2023. The Fed felt that its inflation target of 2% was not in sync with low levels of unemployment as the comfortable household finances would never allow inflation to come down. Hence, the Fed was open to letting the GDP growth drift lower and the unemployment level drift higher. To achieve that, the Fed kept status quo on interest rates in the range of 5.25%-5.50% for a full year since July 2023. The prolonged hawkishness was also one reason for the sharp rise in unemployment in the month of July 2024 as most of the businesses in the US are feeling the acute pressure of higher interest rates.

HOW BAD IS THE LABOUR DATA IN JULY 2024

To be fair, the US labour data for July 2024 was worse than expectations on multiple counts, which is what has raised the spectre of recession in the US. Here is a quick summary of key takeaways gleaned from the labour data for July 2024.

4. The rate of unemployment in July 2024 rose by 20 basis points from 4.1% to 4.3%. In absolute terms, the number of unemployed persons increased by 352,000 to 7.2 Million. Exactly a year ago, in July 2023, the unemployment rate was at 3.5% (defined as full employment), and there were just 5.9 Million unemployed. In short, the number of unemployed has gone up by 1.3 Million in the last 1 year.
5. In terms of sub-groups that showed a spike in joblessness in July 2024 were adult men at 4.0% and whites at 3.8%. The jobless rates for adult women, teenagers, blacks, Asians, and Hispanics showed little or no change in July over June 2024. The layoffs were more pronounced among the people on temporary layoffs, which increased by 249K to 1.10 Million. The number of permanent job losers was static at 1.70 Million in July 2024.
6. The labour force participation rate (LFPR) was static at 62.7%, while the employment to population ratio was also static at 60.0% in July 2024. What is slightly disconcerting is that number of people employed part time for economic reasons rose by 346,000 to 4.6 Million. These are the persons who would have preferred full-time jobs, but were working part time as their hours had been reduced.
7. Another interesting piece of data is that the number of people not in the labour force and currently wanting a job increased by 366,000 to 5.6 Million in July 2024; which is in contrast to a decline in June 2024. This is a section that has also made the unemployment number optically larger. Total non-farm payroll employment edged up by just about 114,000 in July. This is sharply lower than the average monthly addition of 215,000 jobs over the prior 12 months.

As they say in Economics, a few swallows do not a summer make, and so we have just about one month of weak jobs data. It remains to be seen whether the policymakers really count this is as an advance warning signal of recession or just a normal blip on the screen.

ARE OTHER INDICATORS HINTING AT US RECESSION?

In the US, it is not just the labour data that is seen as a reliable indication of a likely recession. Normally, two other data points are also taken into consideration viz. average GDP growth and yield spread between the 2-year bond and the 10 year bond. Let us look at the signals from both these fronts.

On the GDP front, the first advance estimate for Q2-2024 GDP growth has come in at 2.8%. That is double the final GDP growth in the first quarter at 1.4%. However, it is the Q1 GDP growth that must be put in context. It was sharply lower on a sequential basis compared to GDP growth of 4.9% in Q3-2023 and at 3.4% in Q4-2023. That was seen as a first sign that the hard landing which the Fed feared all along may be coming true. We currently have only the first estimate of GDP growth for Q2-2024. If the second and final estimates are also maintained at this level, then we could say that the GDP has decisively bounced back since Q1. Then the GDP may not really be hinting at a recession, since a recession requires 2 consecutive quarters of negative yoy GDP contraction, coupled with other supportive data.

The other data point seen as an indicator of recession is the yield spread between the 2-year and 10-year bonds. Yield curves are closely watched by investors since they provide insights into future economic activity. A simple definition of an inverted yield curve is if the 2 year bond yield is higher than the 10-year bond yield. This is a signal that investors expect future interest rates to decline as economic growth weakens. A normal, upward-sloping yield curve indicates healthy economic growth. If you look at the latest week, the US 2-year bond yields are at 3.84% while the 10-year bond yields are at 3.76%. This inversion has happened for the first time in 25 months, but one week data is too short to take a view. But there is surely a credible indication about a possible recession in the US in the calendar year 2025, if not in 2024.

As of now, the recession indicators are too patchy and limited to be able to take a view. However, even if the data is supportive of such a view, the final call on whether or not it is recession in the US will be taken by the Business Cycle Dating Committee of the National Bureau of Economic Research. For example, in 2022, the US saw an inverted yield curve and 2 quarters of negative GDP growth. However, the NBER did not declare that officially as recession as the jobs data was very comfortable and it was more an adjustment phase. At the end of the day, it would boil down to whether the NBER calls it a recession. However, US recession expectations are likely to roil global markets due to its dominant role in global output, global investments and in global trade. So, will the Fed stretch itself a little more?

WHAT WILL THE FED DO – CUT RATES MORE AGGRESSIVELY?

In the last meeting that concluded on July 31, 2024, the Fed chair gave the first possible indication that rates could be cut in September. However, he had cautioned not to expect more than 1 rate cut in September. But a lot can change when data points to a recession. Let us first look at what the CME Fedwatch is indicating.

Fed Meet	275-300	300-325	325-350	350-375	375-400	400-425	425-450	450-475	475-500	500-525
Sep-24	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	72.5%	27.5%
Nov-24	Nil	Nil	Nil	Nil	Nil	Nil	28.0%	55.1%	16.9%	Nil
Dec-24	Nil	Nil	Nil	Nil	7.2%	35.3%	44.8%	12.7%	Nil	Nil
Jan-25	Nil	Nil	Nil	6.0%	31.9%	44.0%	16.5%	1.5%	Nil	Nil
Mar-25	Nil	Nil	5.7%	30.6%	43.4%	18.0%	2.2%	0.1%	Nil	Nil
Apr-25	Nil	3.7%	21.9%	38.9%	26.8%	7.7%	0.8%	Nil	Nil	Nil
Jun-25	2.2%	14.5%	32.2%	31.8%	15.4%	3.6%	0.3%	Nil	Nil	Nil
Jul-25	7.4%	20.8%	32.0%	26.0%	11.2%	2.4%	0.2%	Nil	Nil	Nil
Sep-25	19.8%	27.5%	28.4%	17.1%	5.9%	1.1%	0.1%	Nil	Nil	Nil

Data source: CME Fedwatch

In the last few days since the labour data was announced, the CME Fedwatch is feeling extremely optimistic that rate cuts will not only be quicker but also substantially front-ended. Here are some key takeaways from the above chart.

• The CME Fedwatch is not assigning a high probability of 72.5% to a 50 bps rate cut in the September meeting. In addition, it is assigning a probability of 83.1% to 75 bps rate cut by November and a probability of 87.3% to 100-125 bps rate cut by December 2024. These shifts have been largely fuelled by the recession fears.
• By the next milestone of April 2025, the CME Fedwatch is estimating a 91.5% probability to rate cuts of 150-175 bps, which is a substantial increase in the long term probabilities. By September 2025, our third milestone, the CME Fedwatch has assigned a probability of 93% to rate cuts to the tune of 175 bps to 200 bps. That would bring the rates much lower than what the quarterly Fed assessment had projected.

However, the CME Fedwatch still shows market expectations. Quite often, the Fed has been at divergence with the CME Fedwatch and the Fed has been right!

WHAT IS THE MOST LIKELY PATH FOR FED RATES FROM HERE?

The joke in economics is that a recession is a recession only if I accept that it is a recession. As of now, the world is expecting there would be a recession and there is nothing concrete on the table. The Fed would be driven by data flows and not by the sentiments as depicted in the CME Fedwatch and the knee-jerk market reactions. The Fed is obviously going to take a more calculated approach to rates. Here is what could happen.

For now, it is very unlikely that the Fed would go beyond 25 bps in September 2024, unless there is a sharp deterioration in the GDP data reported as of the end of August. That does not look too likely. The most likely scenario for aggressive rate cuts is if the inflation falls and the Fed has reasons to believe that lower inflation is being triggered by fears of recession. That is the only scenario when the Fed would try and stretch to 50 bps rate cut in September 2024. Otherwise, it is likely to be business as usual for the Federal Reserve.