We have been talking for some time about the topic du jour, Curve Inversion, and how the Fed are behind the curve in not cutting rates as quickly as the markets think it should. And finally, this made the main non-business news headlines yesterday, which is normally a sure sign that there will be a strong reversal...
Of course, yield curve inversion is important in the US and elsewhere, but it tells us very little about when a recession will actually occur. What is more important is for how long the curve is inverted and by how much. Currently we have barely had 24 hours of the spread between the 2-year and 10-year US bonds being negative, whereas in 1998 for example, we had roughly 27 days of curve inversion between these two bonds.
We also need to take into account one of the reasons for this move. If you were to adjust the yield curve for central bank asset purchases, which total over $11 trillion, then it would likely not be that flat at all. These purchases, and QE programmes around the world, are unprecedented and so this is very different to previous cycles and market moves. (Please note we are very wary of uttering the infamous 'it's different this time' phrase!)
So, even though bond markets are signalling recession risks ahead, economic data in the US especially, is more consistent with a slowdown than an outright prolonged downturn. The last couple of recessions has seen the trough in yield curve inversion occur before the recession starts. After this, the curve starts to steepen, and we then fall into recession.
Indeed, retail sales figures out of the US yesterday confirmed that consumer spending remains robust, underpinned by the lowest unemployment rate in nearly fifty years. Inflation is similarly low and with wage growth stable, consumption which accounts for roughly 70% of GDP is supported. A recession therefore seems unlikely as long as consumption growth remains solid.
We do note that this comes against an outlook for the economy which continues to darken against the backdrop of trade tensions and slowing growth overseas.
August historically produces the worst monthly returns in markets and FX trends are liable to remain choppy and directionless amid swirling market tensions. A premium for safety probably means the dollar will be supported, whilst JPY and CHF should continue to out-perform.
As for the next recession, watch out for a rapid re-steepening of the yield curve. Retrenchment should emerge once the Fed seemingly reacts aggressively to counter economic weakness.
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