Bloomberg News/Landov The U.S. stock market SPX, +0.72% DJIA, +0.73% is near all-time highs, the unemployment rate is near 50-year lows, the Federal Reserve reduced interest rates by 75 basis points in a three-month time period, and the yield curve has un-inverted. So all’s right with the world, or at least the U.S., right?
Not exactly. It’s too soon to sound the all-clear.
As a counter to the good news, tariff wars have constrained commerce, manufacturing activity, business investment and economic growth across the globe. Even China is feeling the effect.
Chugging along
The U.S. economy is chugging along at a rate close to its estimated potential of just under 2%. Nothing more, hopefully nothing less.
Pro-democracy protests are racking countries from Hong Kong to Chile to Lebanon to Iran, which eventually will manifest itself in lost output.
And no, destruction of the capital stock, with its implication for future investment, is not a net positive for an economy as scarce resources must be devoted to rebuilding. (See Frederic Bastiat’s parable of the broken window in “That Which is Seen and That Which is Unseen.”)
If things are going gangbusters as the stock market suggests, then why are interest rates so low across the spectrum of advanced nations?
“The Good News Is the Bad News,” reads the headline of a story by Neil Irwin in the New York Times Nov. 28 print edition.
Crystal balls
The coincident demand for stocks (risk assets) and government bonds (safe assets) says something about the economic future.
“The current level of longer-term interest rates in every advanced nation makes sense only if the world is going to remain in a low-growth, low-inflation mode for many years to come,” Irwin writes.
Of course, crystal balls tend to get cloudier as the forecast horizon lengthens. No one who lived through the 1970s and 1980s would have predicted that we would witness a decade of near-zero or negative interest rates in the developed world — along with persistently low inflation.
If inflation is a monetary phenomenon, which it is, then central banks are doing something wrong.
The low or negative return on safe assets has created some reaching-for-yield in low credit-quality bonds, as central banks have noted. That said, if 2% growth is as good as it gets in the U.S. today, no wonder interest rates are shockingly low.
An economy’s growth potential is circumscribed by the growth in the labor force and in productivity. An aging population and anti-immigrant sentiment are depressing labor force growth while we await the next technological innovation to boost output per hour worked.
Without an increase in either, the slow-growth trajectory remains in place.
Trade risks
While recession fears have abated, trade remains the big unknown. On Monday, President Donald Trump reinstated tariffs on steel and aluminum from Argentina and Brazil and threatened 100% tariffs on $2.4 billion of French imports, such as sparkling wine, cheese and cosmetics, in retaliation for France’s digital-services tax.
There’s also the prospect of additional tariffs on about $160 billion of mostly consumer goods imports from China scheduled for Dec. 15. On Tuesday, at a news conference in London, Trump said it might be “better to wait until after the election” to seal a trade deal with China.
Trump may change his tune after back-to-back triple-digit declines in the Dow Jones Industrial Average DJIA, +0.73% as investors reconsidered their “trade optimism.”
Prior to this week, Trump and his minions had assured us that trade talks with China were “in the final throes” (Trump) or “down to the short strokes” (National Economic Council Director Larry Kudlow).
But there is no deal yet. And even if there were a phase-one trade deal, it would be unlikely to feature either a significant revamping of China’s unfair trade practices or a significant reduction in U.S. tariffs.
To date, China has not retaliated with trade measures in response to the signing into law last week of a bill in support of Hong Kong democracy protesters, confining its response to sanctioning human rights groups and suspending Hong Kong port access to U.S. military ships.
Still, the repercussions from trade wars remain the biggest threat to global economic growth going forward.
Message of the curve
But that’s not all. While decreasing from 38% in August, the probability of a recession in the next 12 months, based on the spread between the 3-month Treasury bill and 10-year Treasury note , stood at 29% in October, according to the Federal Reserve Bank of New York’s model. (The index is updated monthly on the 4th of each month.)
The spread has turned more positive in the last month, which will translate into reduced recession odds when the index is updated later today. But its stellar track record in predicting recession with a long lead time means the earlier inversion can’t be ignored.
Like the 3-month/10-year spread, the spread between the federal funds rate and 10-year Treasury note first turned negative in mid-May and remained inverted until the end of October.
It is highly unusual for the fed funds/10-year spread to resume its normal positive slope before the onset of recession. That’s because the Fed, which never forecasts recession, is generally slow to realize that the die has been cast.
The 3-month/10-year spread, on the other hand, does turn positive before recession begins, suggesting that the market is ahead of the curve — both literally and figuratively.
So what does it all mean? Fed Chair Jerome Powell is probably correct when he says “the economy is in a good place” — and as good as it gets — given its sub-2% growth potential, global growth slowdown, manufacturing recession and trade frictions.
And while the yield curve is no longer flashing red, it remains to be seen whether the Fed acted in time to avert the consequences an inverted curve has historically foretold: another recession.