World Economy

Fed Downplaying Recession Indicator Flashing Yellow

The yield curve is threatening to invert again, with the spread between 10- and two-year treasury note yields now at its lowest level
Growth in consumer spending braked to a 1.1% rate in the first quarter.Growth in consumer spending braked to a 1.1% rate in the first quarter.

Federal Reserve officials and Wall Street traders should be cautious about dismissing an ominous sign emanating from the US Treasury market.

Bonds tend to act rather oddly ahead of recessions as investors begin to expect lower future returns on investment. When that happens, the yield on long-term notes falls below its short-term counterpart. The phenomenon, known as a yield curve inversion, has invariably preceded an economic downturn, Business Insider reported.

The last time it happened was in 2007, just before the economy entered its deepest recession in generations. And now the yield curve is threatening to invert again, with the spread between 10- and two-year treasury note yields now at its lowest level since that fateful year.

Some Fed officials including Chairman Jerome Powell have dismissed the trend as unlikely to be sending any kind of recessionary signal this time, with the Fed still expecting the US economy to grow 2.7% this year and 2.4% in 2019.

"Former Fed Chair Yellen and Chair Powell have downplayed the recent curve flattening," wrote Ruslan Bikbov, interest rate strategist at Citi, in a research note. "We don't find their arguments convincing. The Fed was wrong about the curve before. More likely than not, we believe they are wrong again."

An early reading of first quarter gross domestic product showed an annualized first-quarter expansion of 2.3%, above forecasts but hardly showing any of the bump that some on Wall Street expected on business investment and consumer spending from corporate and individual tax cuts.

Yield Curve

"The extreme optimism about economic growth this year has cooled as the hard data have come in constructive but not exceptional," wrote Michelle Meyer, Bank of America Merrill Lynch's US economist, and her colleagues in their research.

"In the near term, we think all eyes should be on the US consumer to inform us how and when the fiscal stimulus will kick in," she added. "Early survey evidence suggests that consumers may have embraced a somewhat frugal attitude when it comes to responding to the windfall cash from tax cuts."

Deutsche Bank economists predict the curve will invert in 2019 as the Fed keeps raising interest rates by a quarter percentage point every quarter, as markets expect. "If the Fed continues to raise rates according to our forecast and the term premium does not recover, the yield curve would invert by the end of 2019, potentially as early as June of next year," they write in a note.

The real trouble may not come until two years out, they estimate. "Our full recession probability model puts the odds of a recession in the next twelve months at about 10%. Once the forecast window gets further out, however, the yield curve is showing elevated recession probabilities," the economists write. "With our forecast projecting output growth to slow below potential in 2020, the inversion of the yield curve would be a meaningful signal regarding the specter of a looming recession."

Growth Slackens in Q1

The US economy slowed in the first quarter as consumer spending grew at its weakest pace in nearly five years, but the setback is likely temporary against the backdrop of a tightening labor market and large fiscal stimulus.

Gross domestic product increased at a 2.3% annual rate, the commerce department said in its snapshot of first-quarter GDP on Friday, also held back by a moderation in business spending on equipment and investment in homebuilding, Reuters reported.

The economy grew at a 2.9% pace in the fourth quarter. Economists polled by Reuters had forecast output rising at a 2% rate in the January-March period.

The first-quarter growth pace is, however, probably not a true reflection of the economy, despite the weakness in consumer spending. First-quarter GDP tends to be sluggish because of a seasonal quirk. The labor market is near full employment and both business and consumer confidence are strong.

Economists expect growth will accelerate in the second quarter as households start to feel the impact of the Trump administration’s $1.5 trillion income tax package on their paychecks. The tax cuts came into effect in January.

Lower corporate and individual tax rates as well as increased government spending will likely lift annual economic growth to the administration’s 3% target, despite the weak start to the year.

Federal Reserve officials are likely to shrug off tepid first-quarter growth. The US central bank raised interest rates last month in a nod to the strong labor market and economy and forecast at least two rate hikes this year.

Growth in consumer spending, which accounts for more than two-thirds of US economic activity, braked to a 1.1% rate in the first quarter. That was the slowest pace since the second quarter of 2013 and followed the fourth quarter’s robust 4% growth rate.

Consumer spending in the last quarter was undercut by a decline in purchases of motor vehicles, clothing and footwear as well as a slowdown in food and beverages outlays. This likely reflects delayed tax refunds.

Business spending on equipment slowed to a 4.7% rate in the January-March quarter after double-digit growth in the second half of 2017. The cooling in equipment investment partly reflects a fading boost from a recovery in commodity prices.

Government spending grew at a 1.2% rate, slowing from the fourth quarter’s 3% pace. Spending is expected to accelerate in the second quarter after the US Congress recently approved more government spending.

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