The markets have priced in a Federal Reserve rate cut this year, with the likelihood of a September reduction rising to 62% on Wednesday from a 50-50 shot on Tuesday and about a 91% of a 25 basis point cut by yearend.
The three-month to 10-year yield curve widened to negative 8.4 basis points, the largest gap since August of 2007.
Although the Fed has said persistently low inflation could result in a rate cut, the panel’s statements about being patient seem to reflect that level is nowhere close.
Despite parts of the yield curve remaining inverted, until the inversion is 25 basis points or lasts four weeks, there’s not much to worry about, according to Brian Rehling, co-head of global fixed income strategy at Wells Fargo Investment Institute. “Our preferred indicators are the 1y-10y or the 3m-10y, both of which recently inverted, but have not hit our preferred signal and bear close monitoring.”
Those who say this time is different are betting “against history,” he said. “It is not entirely clear exactly why an inverted yield curve has such a strong ability to predict a recession, but the evidence is clear that it does.”
Expected weakening global growth, more than trade issues “are driving the yield curve,” Rehling said, although “trade developments have a significant impact on global growth expectations.”
UMB Financial Chief Investment Officer KC Mathews agreed that that trade issues are slowing global growth. “The longer we go without a trade resolution, the higher the pressure to stimulate the economy with lower yields.”
Other nations’ central banks “will stimulate their economy” if growth slows, Mathews said. “The US will not want to be left behind, thus lower rates may be on the horizon.”
Mathews is not in panic mode either. “We suggest that investors don’t look at just one flavor of inversion, seek out confirmation,” he said. “In the past two cycles the 2-10-year slope inverted first, then a few weeks later the 3 month – 10-year slope inverted providing confirmation.”
While yield curve inversion “is a good recession indicator sooner or later,” he continued, other data, such as, “The Conference Board’s Leading Economic Index (LEI) has a similar track record in predicting recessions” and “tends to be timelier than the slope of the yield curve.”
High-yield bond spreads also can signal a recession as they “typically expand significantly after a yield curve inversion and before the stock market peaks.”
Also, Mathews said, “Historically, recessions only occurred when the fed funds rate is meaningfully above the neutral rate for an extended period. The Fed currently estimates that the neutral rate is 2.80%.” The fed funds rate target is 2.25% to 2.5%, and the Fed sees it remaining there “for the foreseeable future,” he said.
Glenn Grossman, CEO of Dinosaur Financial Group, pointed to slowing growth in China, “Brexit, Turkey sanctions, no movement in Korean situation, unstable politics in at least a dozen countries, EU elections, and what happens in the U.S. after the Trump tax cut” as reasons why the curve is flat.
“Where is there anything to suggest growth has not run its course? Is there any real sign of inflation?” he asked, “And the list of questions goes on.”
Economic indicators
Activity was weak in the services sector in May, while manufacturing improved less than expected. The Federal Reserve Bank of Richmond’s manufacturing composite index rose to 5 in May from 3 in April, “as shipments and new orders had fairly flat reading and the third component, employment, remained positive,” the bank reported. “Firms reported growth in spending and positive overall business conditions, and remained optimistic about growth in the coming months.”
Prices grew slower in May, with prices paid still outpacing prices received.
Meanwhile, the Richmond Fed’s services sector index posted its largest single-month drop since February 2003, plunging to 1 in May from 26 in April. “Firms also reported softening in demand growth and local business conditions,” according to the bank. “However, respondents were optimistic that growth would improve in the next six months.”
The Federal Reserve Bank of Dallas’ Texas Service Sector Outlook Survey confirmed service sector softness, as the revenue index dropped to 2.7 in May from 13.9 in April.
“Texas service sector activity decelerated in May, as revenue growth slowed and labor market indicators softened,” said Christopher Slijk, Dallas Fed assistant economist. “Overall perceptions of current business conditions were weaker than last month, and measures of uncertainty increased. Retailers in particular were pessimistic in their outlooks for future activity.”
