By Gene Balas, CFA®
Introduction: Are We Too Focused on the Yield Curve?
Lately, people have been wondering and theorizing as to whether the U.S. is poised to enter a recession. One of the most noted concerns was the recent brief and shallow inversion of part of the yield curve (with the two-year Treasury yield rising above that of the ten-year Treasury). Often, an inverted yield curve is viewed as a precursor to recession. But this signal has given false positives before—not to mention that the lead time from an inversion can be up to a year or longer before a recession either does or doesn’t occur.
The current yield curve is influenced by several factors; such as the Fed’s intention to tighten policy rates at the short end of the yield curve (sending two-year rates higher), while maintaining its longer-term bond holdings which keeps yields on the longer end of the yield curve lower than they might otherwise be. Geopolitical concerns can also send investors globally into a ‘flight to quality’ trade, pushing longer term yields down, at least temporarily. Given these factors—not to mention that the yield curve is no longer inverted—we might not wish to rely too heavily on that indicator in the current market environment.
First Quarter GDP Report, Explained
Investors were also spooked by the headline print of Q1 real GDP (-1.4%)—primarily reflecting decreases in private inventory investment, exports, federal government spending, and state and local government spending, while imports (which are a subtraction in GDP calculations) increased. Personal consumption expenditures (PCE), nonresidential fixed investment, and residential fixed investment, however, all increased at fairly respectable rates.
In other words, U.S. consumer and capex investment were relatively solid, and demonstrate healthy domestic demand. Demand throughout the rest of the world, on the other hand, was weak (e.g., COVID continues to have a lingering impact, and China has instituted significant economic restrictions). This caused U.S. exports to other countries to fall 5.9% in Q1, while imports rose 17.7%—reflecting strong domestic demand. This trade deficit, driven by weaker overseas economies, played a significant part in the most recent quarter’s U.S. GDP decline.
Then there are inventories to consider—not typically a top-of-mind consideration when conducting an examination of GDP. The change in private inventories was a direct a subtraction from GDP growth of -0.84 percentage points, as inventories were drawn down. Lower government spending (the pandemic stimulus programs have largely ended) accounted for much of the remainder of the decline in GDP. In other words, despite the headline statistic, these factors are hardly indicative of an economy headed into recession.
The Needle Can be Hard to Thread
The tricky task of the Federal Reserve in combatting inflation is to raise interest rates (an action whose effects occur with a lag of many months) by just enough to reduce very high inflation, without pushing the economy into a recession. But remember: the purpose of raising interest rates is most definitely to slow the economy enough to bring demand in line with supply. The labor market has been red-hot, with unemployment rates hovering near record lows, and workers able in many cases to demand (and obtain) higher wages. That can be good for workers – until employers are forced to raise prices to cover the costs of those higher wages. In other words, a wage-price spiral. Then nobody is better off.
The Fed needs to fight this by nudging the unemployment rate higher and weakening the economy—but by just the right amount. On its face, that sounds like a rather perverse thing to do. But high inflation is a problem that affects everyone in the economy—employed or not.
Goldman Sachs’ analysis of historical patterns in the G10 economies “suggest the Fed faces a hard path to a soft landing as it aims to narrow the jobs-workers gap and bring inflation back towards its 2% target,” as noted in a recent research report. The report continued, “We still do not see a recession as inevitable, however, particularly since the FOMC’s goal of cooling the economy while avoiding a recession will be helped by post-covid normalizations in labor supply and durable goods prices.”
In a subsequent report dated May 3, Goldman noted that “actual growth has so far held up quite well, even as stocks have fallen sharply, suggesting that a lot of bad economic news is now already priced into equity markets. And we do not see a recession materializing over the next 12 months. And even over the next 2 years, we assign only a 35% probability.”
Likewise, Bill Dudley, former President of the New York Fed, wrote in an opinion piece in Bloomberg recently, titled, “The Slower the Fed, the Harder the Landing: If a recession doesn’t happen in the next couple years, it will only be worse.”
Like Goldman, he doesn’t see a recession as necessarily likely in the coming year, but instead looks to 2023 or 2024 as a more likely timeframe. He says, “Why no recession this year? For one, the economy has considerable momentum. Ample hiring and wage gains are boosting nominal income. Household finances are in excellent shape: Debt service is at a record low relative to income, and pandemic-related government payments have bolstered savings. All the more reason for consumers to keep spending.”
But Dudley also notes, “The Fed’s choice is clear. If it acts sooner, with inflation expectations still well anchored, the cost in terms of foregone output and higher unemployment should be relatively modest. If it waits and allows inflation expectations to get out of hand, the bill will be much higher.”
It’s a simple truth: recessions can be incredibly hard to predict because people often behave in unpredictable ways. Recall, if you will, the first Gulf War back in 1990. We did have an overleveraged commercial real estate market at that time, but what actually triggered the recession that year was the effect of the war on Americans’ psyches. They simply stopped shopping (also due in part to war-related higher fuel prices) and a recession ensued. But then, as the war drew to a close, consumer moods brightened, and 1991 ended up a robust year for both the economy and the markets.
The current environment bears some similarities to earlier periods. But consumers today have become inured to endless wars, and on balance, they have ample cash in the bank to keep spending. Thus, far, confidence indicators aren’t showing any significant decrease in consumer confidence—nor in spending. Calling for an imminent recession appears to be a difficult case to make right now.
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