Overkill on recession worries

I am looking at the US yield curve as I write this note and I see the 10-year yield is just one-tenth of a basis point above the 3-month yield. And the curve is completely inverted from 6 months to 3 years. Should we be worried? The short answer is no. What follows below is the longer answer, in which I talk of recession as a tail risk and the curve as a signal the Federal Reserve should respect.

Doom and Gloom

There are a lot of worry-worts out there these days on Twitter telling us that we are fast approaching a recession. You might even call them fearmongers. It’s the same group of people who told us that an inverted yield curve in August meant doom for the US economy. I think their fears are warranted but overblown. The yield curve is a signal, not a prediction.

What the curve flattening is telling us is that the market is front-running future Fed policy moves. And if the Fed doesn’t cut in accordance with that frontrun, it risks tightening financial conditions at a time when global growth has decelerated. That would potentially be a policy error that leads to recession. So, the curve flattening isn’t quite a harbinger of recession, but something to help guide policymakers in thinking about their impact on financial conditions.

And, if you think about Maziar Minovi’s framework for thinking about political tail risk I referenced in the last post, it’s similar for monetary policy tail risk; the pre-conditions have to be ripe for tail risk to have a meaningful impact. And then the policy error or large event risk takes us over the edge and produces a recession and/or financial crisis. What I have ascertained from my own analysis and other business cycle analyses that I have seen is that global growth has decelerated but that it has not decelerated so much that a recession is a foregone conclusion in the near-term. It is more of a tail risk that comes from further deceleration, policy error and event risk mixing to form a toxic brew.

The data

Look at some of the recent data releases for example. Yesterday, we got the Q4 2019 GDP print, which was bang on 2.1% estimates. Rolling 12-month real GDP growth is 2.32% through the end of that quarter. And that’s up from 2.07% after Q3. Additionally, the Atlanta Fed is presently nowcasting 1.7% for Q1 2020. All of these data points show a US economy operating above stall speed. And that means, we would need to see a rather sharp deterioration in the data to bring us to stall speed, say 1.0% growth or less. That’s when the economy becomes vulnerable. Right now, the numbers are much too high to be worried in the near term.

Initial jobless claims came out yesterday as well. And the 4-week average of initial claims is at 214,500. That’s lower than year-ago numbers of 223,250. That’s a positive regarding the job market. Continuing claims are higher than year ago numbers. And so, the picture that the claims dataset is painting is mixed. Interestingly, though, continuing claims are receding. So, we may see better year-on-year numbers in the coming weeks.

Finally, I would note that today’s personal consumption data print shows December 2019 personal consumption expenditures 4.97% above year-ago levels. While this brief bump is a statistical quirk, we are still comfortably above the 3% level that I would see as a danger zone for the economy. I expect consumption to fall toward that level though because personal income growth is falling. It peaked in July 2018 at 6.1% in year-on-year terms and has been falling ever since. The December 2019 number is 3.94%.

The bottom line regarding all the data prints though is that they show an economy that will continue to do just fine in the near term. This is not what you’ll hear the doom and gloomers saying.

My view

So I continue to be cautiously optimistic about the US economy. I think the coronavirus is a serious event risk. But I don’t think it is yet to the point where we have to worry about recession. Regarding financial conditions, the recent fall in oil prices is worrying because it creates so much refinancing risk in the oil patch due to the amount of debt rollovers coming due. And I think that the brief yield curve inversion is a warning for the Fed about how it has to message and the tolerance asset markets have for perceived tightening. Overall though,I don’t see reason to worry too much just yet.

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