COLUMN-Markets expect interest rate cuts as economic outlook worsens: KempReuters | Updated: 17-05-2019 21:36 IST | Created: 17-05-2019 21:07 IST
The risk of the United States slipping into recession in the next year is elevated according to most traditional measures, even though policymakers say the economy is in a good place.
The Federal Reserve Bank of New York's yield-curve model implies the probability of the economy being in recession in May 2020 is now about 28-29%, based on the yield spread between three-month and 10-year U.S. Treasury securities. If that probability does not sound particularly high, the implied probability of recession 12 months before each of the last three downturns started was 38% (2008), 26% (2001) and 31% (1990).
The median probability of recession 12 months ahead over the last 60 years has been just 8% and the current recession risk is in the 87th percentile of the distribution since 1959. Federal funds futures prices are now fully pricing in a quarter-point cut in policy-controlled interest rates by the end of the year, as traders anticipate the Fed will cut interest rate as a precaution against a deeper slowdown.
Yields on Treasury securities across the spectrum from six months to 10 years, as well as inflation-protected securities, have been falling in absolute terms as investors anticipate rate cuts and a general flight to safety. With rates on longer-dated securities falling faster than shorter-dated ones, the yield curve is progressively inverting.
The march towards inversion shows no sign of reversing despite optimistic statements from Fed officials, the White House and Wall Street analysts. DIFFERENT THIS TIME?
Some observers have dismissed the warning from the yield-curve model by arguing "this time is different" because of distortions in the Treasury market as a legacy of quantitative easing during and after the last recession. Others note the yield-curve model is based on traders' expectations about the performance of the economy and these could change if incoming data is more favourable.
Policymakers on the interest-rate setting Federal Open Market Committee concluded at their last meeting that continued the expansion of economic activity was the most likely outcome. But the model has a good track record identifying end-of-cycle recessions and serious mid-cycle slowdowns that were bad enough to prompt the central bank to cut interest rates, so it should not be dismissed casually.
Movements in other asset prices are also consistent with the view that the U.S. and global economies are facing a serious loss of momentum or recession within the next year. China's currency has fallen sharply against the U.S. dollar amid growing fears about the fallout from the trade war with the United States.
The International Monetary Fund has downgraded its 2019 growth forecasts for all the advanced economies by an average of 0.2 percentage points since January and 0.3 percentage points since October. The Fund has also downgraded growth forecasts for most major emerging markets this year, including Russia, India, Brazil, Mexico, Saudi Arabia, Nigeria and South Africa.
Elevated recession risks are embedded in a range of asset and commodity prices. Spot oil prices, for example, have remained steady despite multiplying production problems as traders anticipate an economy-driven slowdown in consumption growth.
If the U.S. and global economies skirt recession and regain some of their lost momenta later in the year, there will have to be a major re-pricing of assets and commodities. For the moment, however, traders are anticipating the risks to growth will be severe enough to force the Fed and other central banks to cut interest rates, and those fears are holding down commodity prices.
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