Fed boxed in by yield curve
It is looking increasingly likely the US Federal Reserve has missed its chance to engage in a meaningful interest rate tightening cycle. Globally, 10-year government bond yields have fallen sharply – in many cases to new record lows, in part due to the recent US jobs data and in part the increasing uncertainty over Brexit. This flattening of the yield curve is a strong indicator for a period of sub-par US growth, even if survey data has, for now, improved somewhat during Q2. Whether or not we are looking at a technical US recession is perhaps, technical, as in any case a period of even weak growth is inconsistent with positive surprises for corporate profits and equities.
Exhibit 1: 20th and 21st century US GDP growth trends compared
US GDP growth in this century has been significantly lower on average than in the latter part of the 20th century, Exhibit 1. In fact the real growth rate of the US economy post 2010 has only averaged 1.8%, compared to 3.5% in the 40 years leading up to 2000. Even if there has been a 50bps reduction in year-to-year GDP volatility in the 21st century, the larger reduction in trend growth means that technical recessions have become statistically more likely. We also note that new orders data and the shape of the yield curve have in the past been helpful predictors of short-term cyclical variations in GDP, Exhibit 2.
Exhibit 2: Flatter yield curve and weak new orders associated with below trend US GDP
Over the last 50 years when the slope of the yield curve is less than 1%, US GDP growth over the following 12 months has averaged 0.9% less than trend. Similarly, when the average of the ISM manufacturing and services new orders indices are below average, 12m forward US GDP growth is also on average 0.7% below trend. In the past, during periods when both these variables reached these levels at the same time, 12m forward US GDP growth averaged 1.7% below trend. The current situation is that if the US Fed raises rates again, the slope of the US yield curve will risk falling below 1%, Exhibit 3. Furthermore, even after a sharp recovery from Q1, the most recent average for the ISM manufacturing and services indices is now just below the long-run average of 55.3.
Exhibit 3: Is the Fed now boxed in by the flattening yield curve?
There remains therefore a contradiction between the lagging signals of US unemployment and actual inflation which are close to the Fed’s targets and the forward looking signals coming from the bond market and activity surveys.
There is no doubt a wide range of views on prospective US GDP growth within the Fed itself, based on the conflicting comments which have come from Fed policymakers in recent months. In the final analysis, we believe June’s FOMC meeting will not deliver a rate increase for fear of flattening the yield curve further, in addition to the risk of having to rapidly reverse course in the event of Brexit-induced volatility. However, if the Fed does raise rates regardless, the tight historical correlation between the yield curve slope and US economic activity risks raising expectations that the US Fed is prepared to risk a recession to bring interest rates off the zero lower bound.
1. The slope of the yield curve is indicating a sub-par period of US growth ahead over the next 12m.
2. While a June rate increase is now unlikely in our view, although a single US rate increase during the summer cannot be ruled out the Fed appears boxed in by the yield curve.
3. A lowered trajectory for interest rate increases would validate the recent move lower in bond yields and the US dollar. We did not understand why global equities initially viewed these developments as positive but note recent gains have now reversed.
