Two Key Recession Risks Aren’t Flashing Red – Ironically, Fed Cuts May Change That

To be sure, you don’t have to look very hard for confirmation bias if what you’re looking to do is predict a US recession.

All (good) arguments for why the yield curve may no longer be a reliable indicator of forthcoming economic gloom notwithstanding, you’re reminded that the so-called “OG” of yield curve whisperers (Duke’s Cam Harvey) recently declared that the quarter-long inversion of the 5-year/3-month curve was “the last of four horsemen of the recession to rear its head”.

Given the fact that Harvey wrote the seminal (and first) paper on the predictive ability of the yield curve to forecast US economic growth, it’s at least worth taking him some semblance of serious when he says things like “The clock is ticking. And if the yield curve remains inverted for a quarter, all four horsemen will be riding. Beware.”

That’s just one of Harvey’s four horseman. The other three are (from the blog post linked above):

The first horseman was revealed in a recent Duke-CFO survey, which found half of CFOs are planning on a recession at the end of 2019 or first part of 2020. Eighty-two percent believe a recession will start by the end of 2020. Their job is risk management, and they are overwhelmingly convinced a recession is imminent.

The second horseman is the realization of anti-growth protectionism. The bluster of last year had no real impact on our economy. However, the effects are now more than words — they are decreased trade opportunities. The most famous appearance of the second horseman was the Smoot-Hawley tariffs, which are widely believed to have triggered, deepened, and extended the Great Depression. Don’t just focus on the U.S.-China tit-for-tat. Probably the greatest trade threat is Brexit.

The third is market volatility. This horseman delivers a lot of false prophecies. For example, market volatility spiked during the greatest daily drawdown in modern S&P history, Black Monday in October 1987 — but there was no recession.

Beyond all of that, you can just pick your favorite curve or your favorite indicator. Not a day goes by when one pundit or another doesn’t pop up with what they claim is the definitive recession signal.

Of course, if you’re not into actual data or if you care nothing whatsoever for economics, you might well just point at the chart below (were someone to show it to you) and say that on a common sense read, the fact that we use the term “cycle” to talk about the economy means the currency expansion is likely to end soon, otherwise the word “cycle” may no longer apply – a “cycle” isn’t a “cycle” if it never turns.

(Goldman, BEA)

The Fed obviously knows all of this, and the idea behind preemptive cuts is to help prolong the expansion (well, that, and to avoid the sharp tightening of financial conditions that would invariably accompany a hawkish surprise with markets fully priced for a July cut).

But the assumed Fed rescue aside, there are two other reasons to believe a recession might not be imminent.

“For many investors, the expansion’s already considerable length has been a source of recession anxiety [and] central bankers often push back against this assumption with the familiar line that expansions don’t die of old age”, Goldman wrote Friday, on the way to noting the obvious, which is that while expansions don’t technically die of “old age”, they do die of the symptoms associated with old age.

The bank cites two key risks that typically grow larger the longer the expansion runs.

The first is just the inflationary risk from prolonged periods of very low unemployment. Clearly, this risk has dissipated as the relationship between inflation and the jobless rate has become, to quote Jerome Powell, little more than a “faint heartbeat“. As Goldman writes, “the anchoring of inflation expectations and the flattening of the Phillips curve have structurally reduced the threat posed by inflationary overheating, seen in the steadiness of realized inflation and inflation expectations over the last 20 years”.

That’s well-worn territory.

The second risk the bank flags is progressively larger financial imbalances in the private sector. This has been an issue in the two most recent US expansions (and subsequent downturns).

“In the last two expansions the private sector fell further and further into financial deficit with each passing year in a nearly linear pattern [and] as a result, private sector spending became progressively more vulnerable to a decline in asset prices or a tightening in lending standards”, the bank recounts.

(Goldman)

The good news is, this time around the private sector is not in anywhere near the same kind of shape it was prior to the last two recessions – or at least on this measure (see the footnote on the chart). “The private sector has remained in much better financial shape this cycle and continues to run a healthy financial surplus roughly in line with the historical average”, Goldman writes.

The bank does caution, however, that in a broader sense, financial shocks are “a growing source of potential recession risk due to financial globalization and the greater financialization of the US economy”.

If you’ve gotten this far (850 words in), you probably already know the punchline. In their efforts to avert the downturn clearly telegraphed in the curve (and various other measures), the Fed may end up awakening one or both of the dormant risks Goldman flags.

“Easing the policy rate further is likely to accelerate the decline in the unemployment rate to levels not seen in the US as a whole in a very long time, levels that have sometimes led to undesirably high inflation at the local level”, the bank says, adding that rate cuts are “also likely to push asset values and debt levels somewhat higher, other things equal”.

Oh, the irony.

Damned if he does, and Trump’d if he doesn’t, is Jay Powell.