Date Published: September 3, 2019
It was all yellow. We’re not talking about Coldplay’s hit song, but rather the observation that struck when we updated our Leading Economic Index (Chart 1). It shows six of eight indicators flashing yellow, marking more breadth than previous periods of market angst (Table 1). The last few months have brought forth a seismic shift in several areas of the outlook, supporting the view that the Federal Reserve has sufficient cause to follow through with two more cuts this year. If our economic index continues to deteriorate through year-end, more cuts may yet be on deck for 2020.
Here’s a run-through of just some of the latest developments that suggest now is the time to err on the side of caution:
Against this backdrop, it’s not surprising that recession talk has returned to the front pages of the media and is top of mind among our clients. A deep dive shows that there is no evidence in the hard data that the U.S. is headed for a recession, but some warning flags indicate higher odds over the next 12-24 months.
The incidence of ‘recession talk’ has shot up and sits higher today than prior periods of heightened market angst (i.e. stock market correction in December 2018 and the Chinese revaluation episode in 2015). As Chart 2 shows, the degree of concern is mirroring the period of 2011/12 when, in fact, Europe did tilt into a recession. The U.S. did not follow suit, as the financial and economic linkages tend to be stronger going in the other direction. However, the global economy was a restraint on the U.S. economy, which saw only 1.5% growth in 2011.
A key reason recession talk has increased is directly related to the inversion of the U.S. yield curve. Naturally this didn’t occur in 2011 because much of the dialogue was directed towards Europe. And, importantly, the mechanics were not easy to achieve, with U.S. short-term rates sitting near zero, versus 2.25% today.
Any recession probability model that contains the yield curve as an explanatory variable will show high odds of a recession, typically within the 50-60% range. The NY Fed’s financial model is lower at 31% (as of July 31st), but relative to its history, this marks the highest odds since early-2007. As we’ve discussed in a previous report, this occurs because yield inversion is unquestionably a good signal of a recession. But, its history is not a perfect, and these days the signal may be obscured by unconventional central bank policies. In any event, models where it is the primary focus will always predict high odds once inversion occurs.
The most important piece of the puzzle comes into play when you switch the focus of recession probability models to those that monitor economic indicators. Doing so causes the recession odds to fall measurably within the 20-30% range.
What accounts for the difference? Timing. The signal from yield curve inversion has historically maintained a long lead time of 12-24 months, while those driven by economic indicators generally offer no more than a 3-6 month window. And herein lies a key piece of information. All models are telling us that a period of slower growth is on deck for 2020, particularly as the weight of tariff hikes this year come to fully bear on production and consumer costs. But, the signal has not yet arrived that negative financial market sentiment has bled deeply through the economic data. Nothing is written in stone yet: a recession may be in our future, but that risk is not imminent.
Last year, we published a paper coining the ‘Beetlejuice Effect’, in which recession concerns can become self-fulfilling by altering the hiring and investment behavior of firms. An area of concern in the past month is the potential for a toxic combination created by the high incidence of recession talk and the reinforcement of that sentiment within an inverted yield curve. Neither of these existed when we wrote that report in December.
Within the economic data, here too there’s a new development afoot. Our Leading Economic Index shows six of eight indicators flashing a cautionary yellow. This is not a surprise for those indicators capturing business sentiment and output, as the deceleration in the ISM indicators and manufacturing cycle has been well telegraphed in the data for several months. What caught our eye over the summer was the deceleration in hours-worked (Chart 3). Is this a sign that businesses are responding to uncertainty by pursuing more cautionary hiring? Time will tell if the trend deepens into red territory. If so, it would be harder for the mighty U.S. consumer to stand strong in the face of a compromised job market.
In fact, the timing of the recent trade escalation couldn’t have been worse. We have been perpetual optimists that the U.S. consumer has strong underpinnings and present a key source of upside risk to our forecast. This became reinforced in recent data, showing a second quarter spending profile near 5%. And the third quarter looks like it will have a solid 3%-handle. However, as the full force of the tariffs comes to bear on production and market sentiment, we will be downgrading our U.S. outlook to somewhere in the 1.5% to 1.6% range for 2020. And, the near-term data on consumer spending may not be the best guide for next year.
Consumers are likely to front-load purchases this fall to get ahead of tariff-related price hikes on some of the favorite items. This may make our Leading Economic Index prone to a false signal on the consumer side, requiring us to place more emphasis on what hours and job conditions are telling us, rather than consumer spending patterns. Don’t forget, we have likely not seen the peak in trade tensions, as the U.S. administration will be releasing a ruling on auto imports come November under their Section 232 investigation. Recently Japan has indicated they may have struck a trade deal with the U.S. to avoid a negative outcome, but Europe remains in the cross hairs and marks a larger trading partner with the U.S. than China. A collision of U.S. trade conflicts across two continents could be more than business sentiment is able to bear.
This is why the economics community needs to be humble during this period of extreme political uncertainty. Economic models are not designed for political shocks, it requires a significant degree of judgement by forecasters. Lasting shocks to sentiment and income have larger impacts on the forecast than the direct effects on trade flows from movements in export prices. With the U.S. being the source of political uncertainty, it may lead to stronger feedback loops between the global economy and their domestic economy relative to that 2011 period when recession talk was heightened.
Putting all the pieces together, it would be completely reasonable for the Federal Reserve to continue along the rate-cut course. Doing so now has a foundation that goes beyond simply taking out ‘insurance’. A case can be made that the fundamentals are showing some early evidence of fault lines.
With external risks hitting both business and investor sentiment, we are closely watching for contagion to the broader U.S. and Canadian economies. According to the TD Leading Economic Index, we are not seeing red flags supporting outright contraction, but rather a broad-based weakening. So far, this pattern remains unique relative to what we’ve seen ahead of prior economic downturns, where specific sectors move deep into red territory based on prior excesses (i.e. corporate sector in 2000 and housing sector in 2007).
Nevertheless, the economic backdrop has deteriorated sufficiently to prompt some backstop action by the Federal Reserve. We are calling for 50 bps in cuts by the end of 2019. This action will play through the confidence channel and hopefully provide the necessary support for the economy. Should we get further deceleration in our Leading Economic Index, then even more monetary stimulus will be warranted.
|Table 1: Evolution of U.S. Leading Indicators|
|Date||TDE Economic Index||Consumer Variables||Business Variables|
|2000s Recession (Recession Start: March 2001)|
|Financial Crisis (Recession Start: December 2007)|
Source: TD Economics
|Interest Rate & Foreign Exchange Rate Outlook|
|Fed Funds Target Rate||2.25||1.75||2.00||2.25||2.50||2.50||2.50||2.00||1.75||1.75||1.75||1.75||1.75|
|3-mth T-Bill Rate||1.94||1.70||1.89||2.15||2.40||2.35||2.08||1.73||1.60||1.60||1.60||1.60||1.60|
|2-yr Govt. Bond Yield||1.51||2.27||2.52||2.81||2.48||2.27||1.75||1.50||1.50||1.55||1.60||1.70||1.80|
|5-yr Govt. Bond Yield||1.39||2.56||2.73||2.94||2.51||2.23||1.76||1.40||1.40||1.50||1.60||1.75||1.85|
|10-yr Govt. Bond Yield||1.50||2.74||2.85||3.05||2.69||2.41||2.00||1.55||1.55||1.65||1.75||1.90||2.00|
|30-yr Govt. Bond Yield||1.97||2.97||2.98||3.19||3.02||2.81||2.52||2.00||2.15||2.25||2.35||2.45||2.55|
|10-yr-2-yr Govt Spread||-0.01||0.47||0.33||0.24||0.21||0.14||0.25||0.05||0.05||0.10||0.15||0.20||0.20|
|Exchange rate to U.S. dollar|
|Chinese Yuan||CNY per USD||7.18||6.27||6.62||6.87||6.88||6.71||6.87||7.20||7.25||7.25||7.25||7.25||7.25|
|Japanese yen||JPY per USD||106||106||111||113||110||111||108||106||105||104||103||103||102|
|Euro||USD per EUR||1.09||1.23||1.17||1.16||1.15||1.12||1.14||1.09||1.09||1.10||1.12||1.13||1.14|
|U.K. pound||USD per GBP||1.20||1.40||1.32||1.31||1.28||1.30||1.27||1.20||1.19||1.20||1.21||1.22||1.23|
|Swiss franc||CHF per USD||0.99||0.95||0.99||0.98||0.98||1.00||0.98||0.99||0.99||0.99||0.99||0.99||0.99|
|Canadian dollar||CAD per USD||1.34||1.29||1.31||1.29||1.36||1.34||1.31||1.33||1.33||1.32||1.31||1.30||1.30|
|Australian dollar||USD per AUD||0.67||0.77||0.74||0.72||0.71||0.71||0.70||0.68||0.68||0.69||0.70||0.70||0.70|
|NZ dollar||USD per NZD||0.63||0.72||0.68||0.66||0.67||0.68||0.67||0.63||0.64||0.65||0.67||0.68||0.69|
|Exchange rate to Euro|
|U.S. dollar||USD per EUR||1.09||1.23||1.17||1.16||1.15||1.12||1.14||1.09||1.09||1.10||1.12||1.13||1.14|
|Japanese yen||JPY per EUR||116||131||129||132||126||124||123||116||114||114||115||116||116|
|U.K. pound||GBP per EUR||0.91||0.88||0.89||0.89||0.90||0.86||0.90||0.91||0.92||0.92||0.93||0.93||0.93|
|Swiss franc||CHF per EUR||1.08||1.17||1.16||1.13||1.13||1.12||1.11||1.08||1.08||1.09||1.11||1.12||1.13|
|Canadian dollar||CAD per EUR||1.46||1.59||1.53||1.50||1.56||1.50||1.49||1.45||1.45||1.45||1.47||1.47||1.48|
|Australian dollar||AUD per EUR||1.63||1.60||1.58||1.61||1.63||1.58||1.62||1.60||1.60||1.59||1.60||1.61||1.63|
|NZ dollar||NZD per EUR||1.74||1.70||1.72||1.75||1.71||1.65||1.70||1.73||1.70||1.69||1.67||1.66||1.65|
|Exchange rate to Japanese yen|
|U.S. dollar||JPY per USD||106||106||111||113||110||111||108||106||105||104||103||103||102|
|Euro||JPY per EUR||116||131||129||132||126||124||123||116||114||114||115||116||116|
|U.K. pound||JPY per GBP||128||149||146||148||140||144||137||127||125||125||125||125||125|
|Swiss franc||JPY per CHF||107.4||111.4||111.6||116.3||111.6||111.1||110.5||107.1||106.1||105.1||104.0||103.5||103.0|
|Canadian dollar||JPY per CAD||79.5||82.4||84.3||87.8||80.4||82.8||82.4||79.7||78.9||78.8||78.6||78.8||78.5|
|Australian dollar||JPY per AUD||71.5||81.7||81.9||82.1||77.3||78.6||75.6||72.1||71.4||71.8||72.1||71.8||71.4|
|NZ dollar||JPY per NZD||66.8||76.9||75.0||75.3||73.6||75.5||72.4||66.8||67.2||67.6||69.0||69.7||70.4|
|F: Forecast by TD Economics, September 2019; Forecasts are end-of-period.
Source: Federal Reserve, Bloomberg.
|Commodity Price Outlook|
|Crude Oil (WTI, $US/bbl)||55||76||42||63||68||70||59||55||60||55||56||57||58||59||59|
|Natural Gas ($US/MMBtu)||2.34||4.80||2.02||3.08||2.86||2.93||3.80||2.92||2.51||2.30||2.35||2.40||2.41||2.42||2.44|
|Gold ($US/troy oz.)||1535||1543||1183||1329||1306||1213||1229||1303||1307||1465||1470||1470||1450||1425||1425|
|Silver (US$/troy oz.)||18.70||18.70||14.00||16.74||16.56||15.02||14.58||15.58||14.91||16.60||17.25||17.50||17.50||17.50||17.50|
|F: Forecast by TD Economics, September 2019; Forecast are period averages; E: Estimate.
Source: Bloomberg, USDA (Haver).
|International Interest Rates Outlook|
|ECB Deposit Rate||-0.40||-0.40||-0.40||-0.40||-0.40||-0.40||-0.40||-0.60||-0.60||-0.60||-0.60||-0.60||-0.60|
|3-mth T-Bill Rate||-0.72||-0.79||-0.65||-0.58||-0.84||-0.55||-0.60||-0.70||-0.70||-0.70||-0.70||-0.70||-0.70|
|2-yr Govt. Bond Yield||-0.92||-0.62||-0.67||-0.53||-0.62||-0.61||-0.76||-0.79||-0.76||-0.73||-0.68||-0.54||-0.43|
|5-yr Govt. Bond Yield||-0.93||-0.11||-0.30||-0.09||-0.32||-0.46||-0.67||-0.79||-0.73||-0.66||-0.59||-0.47||-0.37|
|10-yr Govt. Bond Yield||-0.71||0.49||0.30||0.47||0.24||-0.07||-0.33||-0.60||-0.50||-0.40||-0.30||-0.20||-0.10|
|30-yr Govt. Bond Yield||-0.20||1.15||1.02||1.08||0.87||0.57||0.26||-0.05||0.05||0.15||0.35||0.50||0.65|
|10-yr-2-yr Govt Spread||0.21||1.11||0.97||1.00||0.86||0.54||0.43||0.19||0.26||0.33||0.38||0.34||0.33|
|3-mth T-Bill Rate||0.76||0.51||0.59||0.75||0.70||0.75||0.75||0.75||0.75||0.75||0.88||1.00||1.13|
|2-yr Govt. Bond Yield||0.33||0.81||0.71||0.82||0.73||0.64||0.68||0.58||0.68||0.79||1.01||1.24||1.46|
|5-yr Govt. Bond Yield||0.26||1.11||1.03||1.17||0.90||0.69||0.61||0.54||0.64||0.77||0.96||1.14||1.33|
|10-yr Govt. Bond Yield||0.39||1.35||1.28||1.44||1.14||0.99||0.83||0.50||0.60||0.75||0.90||1.05||1.20|
|30-yr Govt. Bond Yield||0.90||1.71||1.74||1.91||1.82||1.55||1.47||1.00||1.20||1.35||1.45||1.55||1.65|
|10-yr-2-yr Govt Spread||0.07||0.54||0.56||0.62||0.42||0.36||0.15||-0.08||-0.08||-0.04||-0.11||-0.19||-0.26|
|F: Forecast by TD Economics, September 2019; Forecasts are end-of-period.
|Global Stock Markets|
|Sep-03||% Chg.||% Chg.||High||Low|
|MSCI AC World Index*||510||-0.8||12.0||532||436|
|*Weighted equity index including both developing and emerging markets.|
|Source: Bloomberg, TD Economics.|
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