Since August 27, when Michael Bauer and Thomas Mertens published their FRBSF Economic Letter titled Information in the Yield Curve about Future Recessions, the ten-year-three-month spread has gone from “nearly 1 percentage point away from an inversion” to low of 15 bps on January 3, 2019. Put another way, investors were willing to lend money for ten years for only 0.15% more interest than for three months, not exactly a ringing endorsement for the future. Why is this happening?
On the short end of the curve, we have an FOMC that is trying very hard to (i) reduce the size of its balance sheet and (ii) normalize rates. While both are laudable goals, the pace/lack of calibration and thoughtfulness of the double-barreled monetary tightening has had a negative consequence on risk assets, which became very quickly apparent in Fourth Quarter. Jerome Powell seemed to be fighting ghosts of inflation past based on lagging indicators like the employment report (which had yet to produce the type of wage inflation predicted by the Philips Curve), while ignoring coincident and leading indicators like commodity prices and the ISM Index of New Orders. The economic weakness was significantly more pronounced overseas but the Chinese buy (or not) new iPhones too.
Globally, there is no question that things are slowing down. According to the IMF, the growth of global exports in US Dollars was showing an increase of only 4.7% at the end of 2018 compared to 14.5% at the end of 2017. According to the WTO, the volume of world trade was increasing at 2.7% at the end of 2018 compared to 5.1% at the end of 2017. Even in the US, ISM Export Orders Index experienced a sharp drop to 52.8 (albeit still expansionary above 50) and both the Bloomberg and Goldman Sachs US Financial Conditions Index showed tightening of financial conditions lately.
There is a certainly a level of what George Soros labeled reflexivity in the events of Fourth Quarter. Throw in a few comments like “we’re a long way from neutral at this point (October 3),” and “I think that the runoff of the balance sheet has been smooth and has served its purpose and I don’t see us changing that (December 19)” from the Chairman of the FOMC and the financial markets start freaking out with risk assets selling off, financial conditions tightening and credit spreads blowing out, all but ruling out any further removal of monetary accommodation.
In their global webinar titled Clouds on the Horizon or Just a Passing Fog, economists Jim O’Sullivan and Carl Weinberg from High Frequency Economics (“HFE”) suggest a few key takeaways.
- World Trade is slowing: The pulse of the global economy is slowing.
- Industrial production and survey data indicate output is faltering in many economies.
- HFE has no indication of inflation risk in any major economy at this time, so…
- Most central banks are not going to tighten in 2019.
- Bond yields, already low, still have room to fall, although negative yields are unsustainable.
