Author: Dr Shane Oliver, Head of Investment Strategy and Chief Economist, published on 19 July 2018.
In the latest, Oliver’s Insights published on Thursday, 19th July 2018, Shane Oliver, looks at the outlook for the US economy, particularly the risk of recession given the flattening US yield curve.
The key points are as follows:
- If you are worried about a major bear market, the US economy is the key to watch.
- While traditional measures of the US yield curve have flattened sending warning signs about future growth, it has given false signals in the past, is still positive and other versions of the yield curve point to rising growth.
- Moreover, apart from very low unemployment, other US indicators still show little signs of the sort excesses that precede major economic downturns, profit slumps and major bear markets.
Ever since the Global Financial Crisis (GFC), there has been an obsession with looking for the next recession. In this regard, over the last year or so there has been increasing concern that a flattening yield curve in the US – ie the gap between long-term bond yields and short-term borrowing rates has been declining – is signalling a downturn and, if it goes negative, a recession in the US. This concern naturally takes on added currency given that the current US bull market and economic expansion are approaching record territory in terms of duration and given the trade war threat.
The increased volatility in shares seen this year, including a 10% or so pullback in global shares earlier this year, adds to these fears. Whether the US is about to enter recession is critical to whether the US (and hence global) bull market in shares is about to end. Looking at all 10% or greater falls in US shares since the 1970s (see the table in Correction time for shares?), US share market falls associated with a US recession are longer lasting and deeper with an average duration of 16 months and an average fall of 36% compared to a duration of 5 months and an average fall of 14% when there is no recession. Similarly, the Australian share market falls are more severe when there is a US recession. So, whether a recession is imminent or not in the US is critically important in terms of whether a major bear market is imminent. This note assesses the risks.
The long US economic expansion and bull market
The cyclical bull market in US shares is now over nine years old. This makes it the second longest since WW2 and the second strongest in terms of percentage gain. And according to the US National Bureau of Economic Research, the current US economic expansion is now 109 months old and compares to an average expansion of 58 months since 1945. See the next two tables. So, with the bull market and the economic expansion getting long in the tooth it’s natural to ask whether it will all soon come to an end with a major bear market.
The yield curve flattens – but it’s complicated
The yield curve is watched for two reasons. First, it’s a good guide to the stance of monetary policy. When short-term interest rates are low relative to long-term rates it indicates businesses can borrow short and lend (or invest) long & this grows the economy. But it’s not so good when short rates are above long rates – or the curve is inverted. And secondly, an inverted US yield curve has preceded US recessions. So, when it’s heading in this direction some start to worry. However, there are several complications.
First, which yield curve? Much focus has been on the gap between 10-year bond yields and 2-year bond yields which has flattened to just 0.3%, but the Fed has concluded that the traditional yield curve based on the gap between 10-year bond yields and the Fed Funds rate is a better predictor of the economy and it has flattened but only to 1%. Moreover, a shorter yield curve based on the gap between 2-year bond yields and the Fed Funds rate predicted past recessions like the longer yield curves but has actually been steepening in recent years which is positive.
Second, the yield curve can give false signals – the traditional version flattened or went negative in 1986, 1995 and 1998 before rebounding – and the lags from an inverted curve to a recession can be long at around 15 months. So even if it went negative now recession may not occur until late 2020.
Third, various factors may be flattening the yield curve unrelated to cyclical economic growth expectations including still falling long-term inflation and real rate expectations, low German and Japanese bond yields holding down US yields and higher levels of investor demand for bonds post the GFC as they have proven to be a good diversifier to shares in times of crisis.
Fourth, a flattening yield curve caused by rising short-term rates and falling long-term rates is arguably more negative than a flattening when both short and long-term rates go up like recently.
Finally, a range of other indicators which we will now look at is not pointing to an imminent US recession.