A Recession Is Inevitable

The Question Is When?

Historically, when the yield spread (difference in yields) between the 2 year US Government Bond yield (gold line) and the 10 year (green line) and 30 year (purple line) narrow close to 0, a recession has followed.

If inflation remains below 2% and slower than expected economic growth suggests that it will remain that way for some time into the future, bond investors will continue to buy longer-term bonds because they will not require the inflation "premium" that they would otherwise want to have as protection from future inflation. Long-term bond prices will rise and yields will move lower (see Paul's Blog from June 14th).

At the same time, the US Federal Reserve (the "Fed") is anticipating that lower unemployment numbers will soon push wages higher which will help drive inflation higher and justify their interest rate increases (which will push the 2 year bond yield higher).

In essence, this will push the yield spread narrower.

So if the Fed is correct and higher wages evolve (although until now lower unemployment has not generated much in the way of wage inflation), bond investors may need to reverse course, which would push longer-term bond yields higher and put the odds of a recession back to later, rather than sooner. 

At the moment however, bond investors, recently whipped in two directions because the so-called "Trump Trade" or "Reflation Trade" bandwagon, that traders jumped on after the election, sputtered and went the other way (i.e. the inflation premium was built-in and then rather quickly taken out). The spread differential between the 2 year bond yield and 30 year bond yield has come all the way back to pre-election levels:

After that differential reached a little over 200 basis points (or 2%), it has come back to below 150 basis points (or 1.5%). If the Fed tightens by 1/4% 2 more times, this spread will narrow to less than 100 basis points (if inflation expectations remain the same for bond investors) or more if the economy slows further.

The Fed owns a lot of bonds (purchased during 3 rounds of Quantitative Easing) that they want to sell to reduce the size of their balance sheet, but they have made that quite clear and bond investors have had time to build that outlook into their expectations.

So it is down to trying to determine who is right on inflation (and economic growth): The historically over-optimistic US central bank (trying to keep consumers confident and spending) or bond investors.

The thing about bond investors is that it is their money that is at risk, so being wrong is an expensive proposition. 

Central bankers are, by and large, economists (pretty smart ones at that) but with no real "skin in the game", other than their reputation (which time always repairs). 

We also know that economy's are cyclical and after 8 years this economic cycle is getting long in the tooth. All the anticipated goodies hoped for from the Trump administration are taking some time to come to fruition and when they finally (if, as and when) do get initiated, there will be some lag time before they have the desired impact.

It may just be in time to help pull the US into the next economic cycle, but first, the current one has to end. 

The question is: when? 

The answer is: stay tuned.

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