THREE TELL- TALE SIGNS OF
A RECESSION The nearly decade-long U.S. economic expansion may look a little long in the tooth, but it is not about to end due to old age. Economic expansions need a catalyst that triggers a downward spiral of consumer and business retrenchment.
In the United States, the most common catalyst has been the collision of rising interest rates and heavy debt loads, corporate valuations that appear to have run ahead of free cash-flow generation, or both. Add trade tensions and geo-political uncertainties, which may work to slow global growth, and we might have a scenario that could trigger a recession, at least at first glance.
While the current environment ticks off all the items on this list, that does not mean a recession is in the cards. Indeed, equity markets have been placid thus far in 2018. After a brief volatility spike in January, implied volatility has subsided to near record lows for equities, many related financial products and precious metals. So far, neither markets nor U.S. macroeconomic data for labor markets or consumer confidence are flashing any signs of concern. We want to examine the recession risk signals and evaluate the probabilities of a downturn coming in the next year or two. Our conclusion is that recession risks are steadily rising, with about a 33% probability of a recession in the next 12-24 months.
RISK #1: RISING RATES AND FLATTENING YIELD CURVE The Federal Reserve (Fed) has been raising rates in its desire to shift
Figure 1: More Rate Hikes Risk Taking the Fed Past Neutral. Fed Funds Futures 1Y and 2Ys Out
0.00 0.50 1.00 1.50 2.00 2.50 3.00
2014 2015 Source: Bloomberg Professional 2016 2017
Source: Bloomberg Professional (FDTRMID, FFZ15, FFZ16, FFZ17, FFZ8, FFZ9, FFZ0), CME Economic Research Calculations
2018
In 1 Year In 2 Years
Current (Mid- Range) Fed Funds
gears, from accommodative to neutral. Given that the Fed is signaling more rate hikes to come, there is a real risk of unintentionally shifting into a high tightening gear.
The metric most clearly signaling that the Fed may go beyond neutral and into the high tightening gears is the shape of the yield curve. As the Fed has lifted short-term rates, longer-term Treasury bond yields have hardly moved, resulting in a major flattening of the yield curve. Economic theory argues that a neutral monetary policy is associated with a modestly positive yield curve. The logic for a slightly positive neutral curve is that short-term rates have less inflation risk than longer-term yields, so risk premiums rise with maturities. As short-term rates rise relative to long-term yields, financial institutions can no longer earn profits from borrowing short and lending long. Commercial businesses depending on short-term credit will face higher interest payments. Consumer debt is not particularly interest rate sensitive, but home mortgages are. Rising short-term rates make floating-rate mortgages less attractive, reducing mortgage choices and decreasing the affordability of buying a new home. All of these impacts are exacerbated if the yield curve actually inverts – short-term rates higher than long-term yields. And, inverted yield curves are an especially good indicator of future recessions 12 to 24 months down the road.
It does not matter why the yield curve flattened or inverted, it only matters that the shape is no longer positively sloped. The cause of the yield curve’s shape change does not matter because economic agents – governments, businesses, consumers – face the change in interest costs and have to react no matter the reason. Aside from the Fed pushing short-term rates higher, this time around, one reason the yield curve has flattened has been that long-term yields did not shift upward with the Fed rate hikes. Long-term yields were constrained due to competition from low yields in government bond markets in Europe and Japan helped by their central banks’ asset-purchase policies. This is certainly true, but just because the cause was different does not mean the outcome will be too.
Then, there is debt. Debt levels have been rising in the U.S. and China, the world’s two largest economies, although not in Europe. Rising debt does not mean an impending recession. Indeed, moderate increases in debt fuel sustained economic expansions. The issue is that higher debt loads mean higher interest payments when interest rates do rise. So, as debt loads increase, the fragility of an economy to rising interest rates increases. Talking just about the U.S., the biggest increases in debt are coming from the Federal government, which means that as interest rates rise the interest expense item in the government budget is going to grow quite rapidly. Consumer and housing debt was way too high in 2007-2008. Consumers cut back for a while but have now returned to the debt loads of 2008. We expect slowdowns in both US auto and home sales due in no small part to rising interest rates hitting high debt loads.
28 | ADMISI - The Ghost In The Machine | September/October 2018
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