Inversion of the US yield curve now points to lackluster projections

Investors have been keeping an eye on the US yield curve since the fall of 2018, as they wonder about a potential inversion and the effects this would have. This is a major issue as inversion of the yield curve is always a flag for economic recession in the US. We can try to convince ourselves that this time will be different … but in vain.

The first step is to look at the trend on the yield curve, and our chart provides daily data since 1983. We can see a clear pattern of yield curve inversion followed by recession with a 12-18 month lag. Each recession is resolutely heralded by an inverted yield curve.

We can take our analysis of US interest rate structures further by looking at the chart opposite.
I have looked at the various interest rates since 1983 – from Fed funds through to the 30-year rate, including the 1-year, 2-year, 5-year and the 10-year of course – and we can see compression as a result of rising Fed funds rates before each recession. Before each recession the Fed’s key rate moves above the others; although the current period does not yet show this configuration as the 30-year rate is still above the Fed funds rate. 

We can see very different situations for the US yield curve over the period from 2018.
A flatter yield curve in the fall of 2018 reflected a swift rise in the 2-year rate to price in expected future Fed moves, and the 10-year rate moved above 3%.
Expected inversion in the curve would then come from a swift hike in the central bank’s rates to curb the risks of excessive nominal growth, as reflected by a rise in the 10-year rate.
The situation changed in mid-November with long-term rates falling. Plunging oil prices changed inflation projections, restricting the 10-year rate’s ability to rise further. 

Since the start of 2019, recovering oil prices – currently at the average price witnessed in 2018 – have not had a major impact on interest rate trends. However, concerns on growth have stepped up a pace and this can be seen in the decline in 10-year real rates. These uncertainties and risks on growth are the result of the China-US battle of wills and these tensions jeopardize future economic growth. The 10-year rate has been below the Fed funds rate since May 7, and this inversion can be seen right across all maturities up to 10 years, although not yet for the 30-year rate, which is falling swiftly but has not yet hit the traditional recession-heralding configuration. The current 30-year rate is 2.75, and around 25 bp remain for it to move into recession-indicating territory. 

The yield curve has reflected the same inversion trend since the fall, but for two different reasons. Initially it embodied strong projections on economic growth, while the Fed endeavored to contain these to avoid the emergence of excessive imbalances. Today it points to lackluster projections from investors, regardless of the Fed’s policies. 
It is easy to envisage the Fed’s role in solving this conundrum: it could cut back its key rate. Yet if we look at the minutes of the last meeting, members of the monetary policy committee are not yet entirely convinced that this is required.
Recessionary risk increases as investor projections deteriorate and everyone sits tight to wait it out. But this is when action is required, although the president does not seem to be persuaded that this type of move is needed.

Why is the euro area slowing? My Weekly column

This post is available in pdf format My weekly column – January 15th

The euro area economy is slowing and could even see a contraction around the end of 2018 due to recessions in Germany and Italy, along with very weak momentum in France. The trend has changed at a faster pace than had been expected at the start of 2018, when the consensus was for similar trends to the very robust growth in 2017 i.e. no acceleration but continued swift economic growth. This pointed to expectations of more self-sustaining growth via jobs, income and investment, thereby driving a more independent trend that could safeguard some of the euro area’s economy against potential external shocks.
This quickening decline is worrying as the situation in a number of countries has gone from solid to shaky, for example Germany, where external trade is now hampering growth, along with Italy and France where domestic demand is no longer on the desired trend.
This quickening decline is worrying as the situation in a number of countries has gone from solid to shaky, for example Germany, where external trade is now hampering growth, along with Italy and France where domestic demand is no longer on the desired trend.

Why this perception of a swift deterioration in the euro area economy?
The first harbinger that all economic observers picked up on is the very swift deterioration in economic indices as measured by business leaders surveys. From a peak in the last quarter of 2017, the composite index slid swiftly and steadily right throughout 2018, failing to display a recovery. This trend is revealed in the euro area Markit manufacturing sector index, which slowed severely and sustainably in sync with world trade, with an accompanying drop in domestic and external orders.

Eurozone recession?

The horizon darkens faster than expected in the Euro zone.
The German figures published this morning (January 8) suggest that the economy is heading towards recession (its GDP had already fallen in Q3). Italy, also with declining GDP in Q3, has negative signals via business surveys. It is also probably in a recession. The French economy lacks vigor, social unrest weighs heavily on the macro dynamics.

In other words, 65% of the Euro zone is probably in decline in the last quarter of 2018 (German and Italian declines do not make up for France’s slight rise). This creates a mediocre momentum and a real concern for the pace of growth of the area for the coming months.
In a context where inflation will be reduced, this will result in poor nominal growth that will not have the ability to create and distribute income. Better coordination of economic policy is a necessary condition (but probably not sufficient) to find a satisfactory trajectory.
Alas, we do not take that path. The two Italian deputy prime ministers blow on the French embers and do not encourage to imagine a serene future.

Germany in recession ?

Recent data on the German industrial production show a rapid drop in the economic activity. The quarterly change was already at -5.5% in the third quarter (annual rate). At the end of November, the carryover for the last quarter of 2018 is at -7.8%.
There is a strong consistency between the quarterly change in the industrial production index and the GDP as it is shown on the graph.
During the third quarter of 2018 the GDP was down -0.8% and related to the strong decrease in the German production this winter, the GDP may again shift downward in the last quarter. Germany would then be in recession.
The impact could be strong on the Euro Area’s momentum and leading to a downward revision of the EA growth forecast (the starting point for 2019 would be lower). The convergence to potential growth (1.6%) would then be quicker than expected.
The ECB will not change its monetary policy before long.