Recent data have sent recessionary bells ringing and investors have been scrambling for safety. We look into the 3 key metrics that have been screaming that a recession is imminent!
But first, to understand why we are talking about a possible recession, we have to look into what has happened over the last few years. Back in 2020 when the global economy was hit by the covid pandemic, this resulted in the perfect storm of supply chain disruptions, increased demand for goods, labour market imbalances, expansive monetary and fiscal policies, and the rising of commodity prices. Which in turn saw the US inflation climb to a 40-year high of 9.1% by June 2022.
In order to combat the increasing inflation rates, the US Federal Reserve started hiking interest rates aggressively from March 2022 to the current levels of 5.50%. Now with the inflation rate down to 3%, the US Federal Reserve has started signaling that they are ready to start cutting rates, possibly at the next meeting in September.
Looking at the Federal Reserve rate decision over the years and overlaying with when the US economy was in a recession depicts a scary trend. The last few times that the Fed cut interest rates from their peak, a recession followed. But if we look more closely at the previous recessions we can see that rate cuts came after the recession started, as a way to get the economy out of recession.
It's also important to remember that the Fed is now planning to cut rates not because it thinks a recession is imminent. The reason why the Fed is cutting is because they have hiked so aggressively in the previous year to bring inflation down, and now that inflation rates have come down, they can actually cut rates."
1. This brings us to our first key metric, the unemployment rate. Rising unemployment rates are a key indicator of a potential recession!
The Federal Reserve had previously indicated that while the employment data was still strong, there was no rush to cut rates. However, at the most recent meeting, Chair Powell from the Fed Reserve stated that “there was a real downside risk to employment numbers” and they “had to find a more equal balance between their employment and inflation goals”.
Coincidently, last Friday, the US unemployment rate was released at 4.3%. The unemployment rate has actually been rising since March 2024 from 3.7%.
This also triggered something known as the "Sahm rule". Named after American economist Claudia Sahm, the rule says that if the average unemployment rate over three months is half a percentage point higher than the lowest level over the past 12 months then the country is at the beginning of a recession. In this case, the US unemployment rate rose in July, so the three-month average was 4.1%. That compares to the lowest level over the last year which was 3.5%.
Persistent increases in unemployment rates often signal that the economy is contracting. Rising unemployment becomes a problem especially as more people lose their jobs, they will have less disposable income leading to a decline in consumer spending. This reduction in spending can further slow down economic growth. When businesses face economic difficulties, they often cut costs by first reducing their workforce, creating a negative feedback loop. Additionally, high unemployment can lead to decreased consumer confidence, causing people to save more and spend less, further worsening the economic slowdown.
2. And this leads us into the second key metric, consumer spending.
Consumer spending has helped carry the U.S. economy past recession forecasts in 2023 and had remained resilient even through continued high inflation and interest rates that remain at two-decade highs.
However, there is rising concern that the pace of consumer spending, a core engine of the economy is slowing, as weaker personal income and lower discretionary spending result from the rising unemployment rate. Economists expect consumer spending growth to moderate through the later part of 2024.
The effect of interest rates can be seen on consumer spending in some categories, as pandemic-era savings are spent down. The high interest rates have left a mark, especially on large ticket items like motor vehicles and other large durable goods, which often have to be financed.
Consumer spending is a key indicator for predicting economic recessions because it accounts for a significant portion of GDP, reflecting on overall economic activity. A decline in consumer spending can reduce business revenue, leading to cutbacks in production, layoffs, and reduced investment, all contributing to an economic downturn. However, consumer spending is just one indicator among many broader economic indicators like unemployment, interest rates, and inflation, which are also essential for assessing the likelihood of a recession.
3. And we come to the 3rd key metric, the inverted yield curve
The US Treasury yield curve can indicate a recession through an inverted yield curve. Historically, an inverted yield curve has preceded many recessions, making them a closely watched indicator by economists and analysts.
Typically, longer-term investments yield higher returns to compensate for the risk of tying up funds for a longer period. This principle stems from the time value of money, where the money available today is more valuable than the same amount in the future due to its potential earning power.
Investing for a longer duration means forgoing other potential uses of that money during that time. Moreover, longer-term investments carry greater uncertainty and risk (such as economic fluctuations, interest rate changes, inflation, and geopolitical events) which can significantly impact long-term investments. To offset these risks and the opportunity cost of tying up funds, investors demand higher returns.
Therefore, the higher yields on longer-term bonds act as a premium to compensate investors for the added risk, uncertainty, and reduced liquidity over time.
An inverted yield curve is significant because it suggests that investors have lower expectations for future economic growth. It often reflects concerns about future inflation or a lack of confidence in economic prospects, prompting investors to prefer safer long-term investments despite lower yields.
When comparing against the 10-year Treasury yield to assess recession risk in an inverted yield curve, analysts often look at the following shorter-term Treasury yields:
2-Year Treasury Yield: This is one of the most common comparisons. An inversion between the 2-year and 10-year yields (when the 2-year yield is higher than the 10-year yield) has historically been a reliable indicator of impending recessions.
3-Month Treasury Yield: Another widely used comparison is between the 3-month and 10-year yields. An inversion here is also considered a strong recession signal. The Federal Reserve closely monitors this spread.
1-Year Treasury Yield: While less common, some analysts look at the 1-year yield in relation to the 10-year yield for additional insight.
However, when investors anticipate economic downturns, they often look for safer investments. Longer-term bonds are considered safe because they provide steady returns over a long period.
As more investors buy these long-term bonds, the demand increases, which in turn lowers the interest rates or yields on these bonds. This is why the yields on longer-term investments can decrease when there are fears of an economic slowdown. The current 3-month, 2-year, and 10-year treasury yield clearly shows the development of an inverted yield curve.
So are we in a recession? Not necessarily.
While we do have the 3 key metrics of a rising unemployment rate, lower consumer spending, and an inverted yield curve, to signal the possibility of a recession, there typically also needs to be some shock that happens for an economy to get into a recession.
Remember, correlation does not imply causation, especially in the financial markets. Eventually, we will have a recession. Recessions are just part of a normal economic cycle. So you shouldn’t hold your breath for one.
If and when interest rate cuts come, this could help pull the U.S. out or delay it. Ultimately, we look forward to further market developments, the possible reactions from the Federal Reserve, and their actions in the upcoming September meeting.
You can watch the video here: https://youtu.be/8_J3HwgCvPk
Comments